Americans work hard to sock away money for retirement. Whether it’s through an IRA or an employer-sponsored 401(k), saving up takes hard work and discipline: they need to diligently contribute from every paycheck, take advantage of employer matches, minimize applicable fees and charges, and select funds that meet their retirement strategies.
However, all that hard work is erased when making an early withdrawal. Across the U.S., there is an increase in withdrawals from 401(k) plans for non-retirement needs. Back in 2010, penalized early distributions stood at an estimated $60 billion, up from $36 billion in 2004. Let’s review whether or not this leakage of retirement funds is worth it.
We wrote this article for individual investors who want to know more about tapping into their retirement savings. If you’re an employer thinking about whether or not to offer hardship withdrawals and loans as options on a 401(k) plan for your employees, we’d recommend this article instead: What Employers Need to Know About 401(k) Loans and Hardship Withdrawals
The math behind an early withdrawal from your 401(k): An example case
Let’s imagine that you’re 35 years old and you’ve just lost your job. Fearing that your job search might take longer than expected and to prevent a cash crunch, you decide to fully liquidate your 401(k) with a fully-vested balance of $15,000. Assuming that you have a 15% federal income tax rate and a 10% state income tax rate, here’s a breakdown of what would happen to your $15,000:
|Original 401(k) balance||$15,000|
|Early withdrawal penalty (10%)||-$1,500|
|Required federal tax withholding||-$3,000|
|Federal tax withholding refund you should receive||-$750|
|State tax you will owe||-$1,500|
|Amount you’ll receive from your 401(k)||$9,750|
You would pay a total of $5,250 and end up with only 65% from your initial $15,000!
The government wants you to keep your money in these accounts for a long time, so they use these tax penalties to strongly discourage you from withdrawing prematurely before your actual retirement.
However, this isn’t even the whole story for that early $15,000 withdrawal. You must also take into consideration your missed gains if you were to rollover that $15,000 into an eligible retirement account. Assuming that your target retirement age were 65, you would miss out on a much larger amount by the time you reach retirement in 30 years.
Here are some examples of how far that $15,000 could go in 30 years at different annual rates of return:
|Annual Rate of Return||Potential Future Value in 30 Years|
While you may think that you may have a hard time finding a new employer offering an eligible retirement plan that you could roll over your 401(k) balance, keep these two points in mind. First, you have 60 days from your last day of employment to make an indirect rollover to a qualifying retirement account. Second, several financial institutions offer IRA plans that you could use to prevent a large tax bill and keep your entire balance to continue building up your nest egg.
To learn more about 401(k) rollovers, read:
An alternate option: 401(k) loans (be careful!)
Of course, you may be thinking that taking a loan out from your 401(k) plan is very different from taking an early distribution from your 401(k) plan. The reality is that any 401(k) loan can turn into a taxable distribution and trigger applicable taxes and penalties. A study from the National Bureau of Economic Research (NBER) estimated the total outflow from defaulting 401(k) loans in the U.S. at $6 billion per year.
Out of a sample of more than 900,000 retirement account holders over a five-year period, one in every ten borrowers defaulted on a 401(k) loan. There were three reasons behind defaults. First, 40% of surveyed plans allowed workers to take out two or loans at once. Second, the average amount for new loans was about $7,800 and the average amount of all loans was about $10,000. Third, 86% of borrowers who separated from their employers defaulted on their outstanding loan balances.
This is why it doesn’t make sense to take a loan from your 401(k). Taking that first loan often increases your chances of taking a second or additional loans and increasing the amount borrowed. The NBER study found that plans permitting multiple loans disproportionately induce young and low-income participants to borrow more. While you generally have up to five years to repay a 401(k) loan, you have only 60 days to pay back an outstanding balance once you separate from your employer. Only 14% of 401(k) borrowers were able to pay back their loans after separating from their employers. Imagine not only getting hit with a pink slip, but also with an unexpected large tax bill two months later.
A word about hardship distributions
Life happens. Sometimes it throws the whole financial kitchen at you and you may have to tap into funds that you firmly vowed to keep untouched. However, you need to keep a clear definition of what truly qualifies as a hardship. The IRS provides a clear list of expenses that are deemed to be immediate and heavy:
- certain medical expenses
- costs relating to the purchase of a principal residence
- tuition and related educational fees and expenses
- payments necessary to prevent eviction from, or foreclosure on, a principal residence
- burial or funeral expenses
- certain expenses for the repair of damage to the employee’s principal residence
Fixing a car, buying a new boat, or replacing expensive computer equipment generally won’t qualify for a hardship distribution.
The IRS states that not all plans are required to provide for hardship distributions, that hardship distributions from a 401(k) cannot be rolled over into an IRA or another qualified plan, and that you’re still liable for income taxes and penalties.
The bottom line: Early withdrawals on your 401(k) aren’t worth it
Making early withdrawals and taking loans on your 401(k) aren’t worth it because they add preventable costs at the time they take place and effectively reduce the potential size of your 401(k). The main advantage of a 401(k) is the potential of deferring taxation until retirement when you have the higher potential of being in a lower tax bracket. By taking an early withdrawal, you’re foregoing that tax advantage and any future growth for your retirement contributions.
Insufficient emergency savings have the strongest association with early withdrawals in defined contribution plans (source). Households that lack emergency funds are twice as likely to tap into their retirement accounts. Therefore, a key way to prevent early withdrawals is to start and strengthen your rainy day fund.
Recommended reading: Emergency Fund Basics: When, Where, and How Much?