The Extremely High Costs of Taking Early Withdrawals from Your 401(k)

Melissa A. Seamon, CFP®

Senior Financial Advisor

Due to rising costs and a troubled economy, a record number of Americans are dipping into their 401(k) plans to stretch their budgets. While it may be unavoidable for some, it should only be considered as a last resort. It is essential to understand what early withdrawals can cost in terms of reduced retirement savings.

Early withdrawals can lead to the follow penalties:

· A 10% penalty on the amount withdrawn before age 59 ½ (some exceptions apply).

· Income tax on the withdrawn amount which could raise your tax bracket.

· The lost opportunity to generate future returns on the withdrawn money.

The worst-case scenario is withdrawing funds during a market decline. Not only does it result in less available capital, but also a permanent loss of capital. That is true whether you withdraw the funds from your 401(k) account or cash out of your investments to avoid further market declines. It may feel better at the moment to be free of frightening market volatility, but the damage to your long-term investment performance may be irreparable.

Avoiding the 10% Penalty

There have always been exceptions to the 10% penalty rule. The IRS will waive it under any of the following circumstances:

· You take a series of equal payments annually from your account for at least five years or until age 59 ½. These are called equal periodic payments.

· You leave your job in the year you turn 55 or later.

· You become disabled.

· You get divorced.

· You gave birth to a child (up to $5,000 per account).

· The IRS grants relief if you are the victim of a disaster.

· You are a military reservist called to active duty.

· You borrow up to $100,000 from your 401(k) and repay it within five years. (The amount not repaid will be penalized!)

In addition, the recent enactment of the SECURE Act 2.0 grants all 401(k) accountholders the opportunity to take an early withdrawal of $1,000 a year for a self-proclaimed emergency starting in 2024. A “self-proclaimed emergency” is at the discretion of the account holder and will only come into question if the account holder is audited by the IRS.

It has become too easy to withdraw money from a 401k), but, in many cases, it can be difficult to put the money back, resulting in a permanent reduction of your retirement savings.

The Real Impact of Early Withdrawals on Retirement Savings

While taxes and penalties are the obvious costs of early withdrawals, they pale compared to the lost opportunity of compounding returns over time. For example, if you withdraw $20,000 from an account averaging a 6% return at age 37, there could be $102,000 less available for your retirement. That is a significant amount of money.

If you wait until age 47 to withdraw the $20,000, you could have $56,000 less in your retirement fund—almost three times the withdrawal amount.

Missing the Best Days of the Market

Worse, if you cash out of the market during a market decline, you will likely miss out on some of the best returns in the market, permanently hurting your long-term investment performance.

Consider the last major stock market crash in 2020. During the worst periods of that steep decline, two days had more than a 9% gain in the S&P 500. Both days were among the top ten return days in the market's history. The first occurred on March 13, just one day following the second-worst return day in twenty years. The second 9% burst occurred the day after the market crash bottomed on March 23. The market then surged 40% from the March bottom in the following months.

If you abandoned the market in early March, as many investors did, and missed the five best return days when it rebounded 40% over the next six months, your portfolio would have lost nearly 30%, which would have been locked into your investment performance.

The bad news is that when you eventually get back into the market, you will need to generate 42% in returns just to recover from your 30% loss. And, without the benefit of some of the best days in the market, it could take as many as four years to get there.

Seek Financial Guidance First

In some cases, taking an early withdrawal may be unavoidable. If you need the money and have exhausted all possible alternatives, you need the money. However, it is critical to understand its implications on your retirement goals so you can properly adjust your plan. Your financial advisor can help you understand its impact on your retirement and help you consider ways to minimize the damage.

If you are in need of a financial ally who can help you navigate the financial complexities of retirement, we encourage you to schedule a call, learn more about our services, and see if Gardey Financial Advisors could be a good match. We best serve clients looking for exceptional client service, who value a long-term partnership, and have a minimum of $500,000 in investable assets.

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Resources:

1. IRS Publication 575: Pension and Annuity Income - Early Withdrawals: This IRS publication provides information on the tax implications and penalties of early withdrawals from retirement accounts, including 401k plans. You can access it at: https://www.irs.gov/pub/irs-pdf/p575.pdf

2. Bankrate: How Much Does it Cost to Cash Out a 401k? This article from Bankrate provides an overview of the fees and penalties associated with early withdrawals from 401k plans. You can read it at: https://www.bankrate.com/retirement/401k-cost-to-cash-out/

3. NerdWallet: Early 401k Withdrawals: What You Need to Know: This article from NerdWallet explains the tax implications and penalties of early 401k withdrawals and provides tips on how to avoid these costs. You can find it at: https://www.nerdwallet.com/article/investing/401k-early-withdrawal

4. Investopedia: What Are the Penalties for Early Withdrawal of 401k Funds?: This article from Investopedia explains the tax implications and penalties of early 401k withdrawals and provides examples of how these costs can add up over time. You can read it at: https://www.investopedia.com/articles/personal-finance/102115/penalties-early-withdrawal-401k-funds.asp

5. The Balance: What's the Penalty for Withdrawing from a 401k Early?: This article from The Balance provides an overview of the penalties and taxes associated with early 401k withdrawals and offers tips on how to avoid these costs. You can access it at: https://www.thebalance.com/whats-the-penalty-for-withdrawing-from-a-401-k-early-2388246