For some investors, it might be tempting to tap into your 401(k) to help pay down debts, purchase a home or take a once-in-a-lifetime vacation. However, doing so may seriously cost you, both now and in the future. Here are some disadvantages of cashing out a 401(k) early.
Taxes and Penalties
Unless your 401(k) withdrawal meets the requirements of a few exceptions permitted by the IRS, such as unreimbursed medical bills that exceed 10% of adjusted gross income or becoming totally and permanently disabled, you must pay a 10% penalty plus any applicable taxes on the withdrawal.1 Any amount withdrawn before you are age 59 1/2 is treated as ordinary income, potentially putting you in a higher tax bracket. 2
If you make any income-based payments, like student loans, taking an early 401(k) withdrawal may increase your taxable income for the calendar year. This income increase may cause these income-based payments to rise until you file your next income tax return.
For example, if you take a $10,000 early 401(k) withdrawal and are already in the 22% tax bracket, you may net only about $7,200 after paying a $1,000 IRS penalty plus a 22% tax rate on the remaining $9,000. Those in higher tax brackets, paying the highest 37% tax rate, could end up with as little as $5,670 from their $10,000 withdrawal after paying the penalty and income tax.3
Loss of Potential Future Gains
The other way an early 401(k) withdrawal might cost you is the potential loss of future investment earnings. Leaving money in your 401(k), instead of withdrawing it, might help you earn more for your retirement. However, investing involves risks, including the possible loss of principal. No investment strategy or risk management technique has the ability to guarantee return or eliminate risk in all market environments.
A 401(k) contribution is limited for each tax year, depending on a person’s age. In 2021, the limit is $19,500 for those under 50. This limit is $20,500 in 2022. It may be harder to make up for any withdrawal by contributing more in the future. The annual catch-up limit is an additional contribution of $6,500 in both 2021 and 2022 for those 50 and older.4 When you factor in the potential of investment growth, a relatively small withdrawal may wind up costing many thousands of retirement dollars.
Important Disclosures
This material was created for educational and informational purposes only and is not intended as ERISA or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
1 https://www.bankrate.com/retirement/ways-to-take-penalty-free-withdrawals-from-ira-or-401k/ (Nov. 18 2021)
2 https://www.investopedia.com/ask/answers/101314/how-do-you-withdraw-money-your-401k.asp (Nov. 28 2021)
3 https://www.forbes.com/advisor/taxes/taxes-federal-income-tax-bracket/ (Nov. 10 2021)
4 https://www.cnbc.com/select/401k-ira-contribution-limits-2022/ (Dec. 14 2021)
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