What does your ideal retirement look like? While everyone’s answer to this question will vary, most people would say they want it to be worry-free, especially after the challenging couple of years we’ve all had. Although the ideal retirement might look different from person to person, the one thing all retirees have in common is the need to have enough funds to support them throughout their retirement years. One of the best ways to achieve this goal is with a fully funded retirement to invest in and grow your 401(k). If your employer contributes to or even matches the funds you put into your account, it will grow even faster!

However, life is unpredictable, and sometimes unforeseen circumstances may tempt you to dip into your retirement piggy bank early. While this may seem like a good idea, doing so could hurt you in the long run. If you are thinking about cashing out your 401(k) early, consider the following consequences and take time to search for alternative options.

Early 401(k) Withdrawal Consequences

It may be comforting to think you have a hefty savings account for the unexpected, but digging into your retirement accounts for anything but retirement is definitely too good to be true, even though about 51% of investors have done it and 1 in 5 have taken a withdrawal during the pandemic.(*1)  But just because others are doing it, remember that this one seemingly simple financial decision can take a huge toll on your future retirement.

Withdrawal Penalties

To motivate us to keep our money set aside for our retirement years, the IRS penalizes 401(k) withdrawals prior to age 59½ by slapping a 10% penalty on the amount you withdraw.(*2)  You may have heard about some exceptions to this penalty, such as in the case of a disability or using the money to pay for certain medical expenses.(*3)  But before you head to your HR department to start the process, remember that it’s not just the 10% penalty you need to worry about, it’s taxes too.

Tax Penalties

A major perk of contributing to a traditional 401(k) is that you save on taxes now and only pay tax when you withdraw the money in retirement. But if you withdraw the money early, not only will you get taxed on your income earned from working, you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket.(*4) This adds up more than you might realize. Between these two immediate consequences, it’s possible you would only keep less than 70 cents out of every dollar you withdraw early.(*5) 

Growth and Goals

Then there are the long-term consequences of cashing out before age 59½. When you save for retirement, you reap the benefits of compound interest, which helps the money you put away grow faster due to interest building upon itself. It means that not only do you earn interest on your principal, but on the interest you’ve already earned as well, so you are earning interest on interest. If you take any part of your 401(k) out, you are losing potential growth. This is a critical point that most people lose sight of when they only look at their short-term financial situation.

Your money is earning money for itself by just sitting there. Without compound interest, it would be incredibly difficult, even impossible for most of us, to earn enough to sustain us in the future. When you withdraw money that was growing, you put yourself behind on reaching your goals and with less time to build your accounts back up again.

How an Early Withdrawal Could Hurt You

Cashing out a 401(k) may seem harmless, but once you look at the numbers, you can see how much it’ll hurt your pocketbook in the future.

Let’s say Michael (30 years old) withdraws $25,000 from his 401(k) to pay off student loans. Since he earns $70,000 a year, he is taxed 22%, but his withdrawal pushes him into a higher tax bracket for 2022 and he will be taxed 24% instead.(*6)  On top of that, he lives in California and faces a 9.3% state tax.(*7)  Here’s the math:

$25,000 distribution

‒ 24% federal tax ($6,000)

‒ 10% early withdrawal penalty ($2,500)

‒ 9.3% California tax ($2,325)

= $14,175 total distribution!

That’s a substantial loss. Not only did Michael sacrifice more than $10,000 at the front end, but he also forfeited the compound interest on the $25,000, an amount that could take him years to invest again.

An Alternative Option

If you ever find yourself in a tough spot financially and are considering cashing out your 401(k), it’s more than worth it to speak to a financial advisor before making any rash decisions. It may turn out that you have other, less financially devastating options available to you, such as taking out a loan on your 401(k) or taking a hardship withdrawal.

Whether you have questions about cashing out your 401(k) or you’re interested in creating a personalized financial plan to reach your goals, the Cypress Wealth Services team is happy to help. Call us at 866.888.6563 or contact one of our offices today.

About Cypress Wealth Services

Cypress Wealth Services is an independent RIA firm providing financial planning and investment management to high net worth individuals, families, business owners, and institutions. Cypress Wealth Services comprises professionals with diverse backgrounds and extensive experience and qualifications. Cypress Wealth Services is uniquely qualified to serve a broad range of client needs, and their experience and expertise act as a foundation for their client service process. The firm uses The Second Growth, which focuses on efficiently protecting, growing, and transferring the wealth and legacy a person has already built to their loved ones. With financial advisors in Palm Desert, CA, Tustin, CA, Athens, GA, and Anchorage, AK, the firm serves clients across the country in Wealth Management Services, Fiduciary Services, 401(k) Design and Management, Investment Reporting Services, Financial and Retirement Planning, and more. For more information, visit www.CypressWS.com or call 760.834.7250.

(*1)-- https://www.bankrate.com/retirement/retirement-savings-survey-november-2021/