Contributing to a 401k is one of the best ways to build up retirement savings. The tax advantages (link to tax advantages) of the 401k make it a great investment option. When combined with the tax advantages and employer match you can save a ton of money really fast. Sometimes with having so much money in one account, it can be tempting to draw from it. With a 401k you should be aware of some special rules when drawing from it.
The main consideration if you want to draw from a 401k is knowing if you are subject to a penalty. If you withdraw from it before you are 59 and 1/2, you are subject to a penalty in the form of extra tax. This penalty for withdrawing early is income tax and an extra 10% penalty. An extra 10% penalty does not sound like much, but in reality it can have some serious long term effects.
Before we talk about what to consider if you want to withdraw early, let's see how much it will really cost you. Knowing the exact numbers will help you make you a more informed financial decision.
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To get an idea of how much an early withdrawal will cost you let's set up a hypothetical scenario. Our example person, Megan, wants to withdraw $7,000 from her 401k. Megan makes $67,000 a year and her highest income tax bracket is 22%. Here is what withdrawing $7,000 early will look like:
|22% income tax||$1,540|
|10% early withdrawal penalty||$700|
Remember that you will likely be paying a higher tax rate (without the extra 10% penalty) on your money now versus later. The reason being that your taxable income will likely be much lower in retirement. Withdrawing now will cost you both a penalty and higher tax right now. This is one of many reasons why it is often not suggested to withdraw early.
If you wanted to do the math for yourself, the steps would look like this. You first need to know the following:
I say the state income tax rate is optional because some states don't have income tax and I normally use just fedreal to estimate my tax bill. This obviously isn't as accurate, but allows me to get an idea of my taxes faster.
Once you have the above information you can now calculate for yourself. To get the total tax percentage you will pay do the following:
federal income tax rate + 10 %
For example, if your tax rate was 22%, your total would be 32%. After you have your total tax percentage do the following:
The amount you want to withdraw x total tax percentage
Following our previous example, the math would be:
$7,000 x .32 = $2,240 total tax bill
Most advice will tell you to not withdraw early from your 401k. Sometimes you can't avoid it and every situation is different, but on average it is best to keep you money in your 401k as long as possible. Here are some items you want to think about before deciding to withdraw.
Because 401ks have a contribution limit of $19,000 a year ($25,000 if you are over 50) you could make up any amount you draw from your account. If you were to draw a large amount, you may never be able to recover your balance. Even with the extra $6,000 catch up once you are 50 it can be hard to make up any lost time with a 401k.
The real value of investments is allowing them to grow over long periods of time. The mantra goes time in the market beats timing the market. Meaning stay in as long as you can. If you are withdrawing early it can mean that you aren't allowing the magic of compound interest to take it's course.
The difference in your balance can be massive with an early withdrawal. If you had $40,000 in your 401k and just left it there for the next 20 years you would have over $154,000 dollars.
Starting amount: $40,000 | Additional yearly: $0 | Growth Rate: 7.0%
Value after 20 years: $154,787.38
If you drew $15,000 from your balance and then continued to contribute $1,000 a year you still wouldn't catch up if you just left it. Sometimes doing nothing can be the best thing.
Starting amount: $25,000 | Additional yearly: $1,000 | Growth Rate: 7.0%
Value after 20 years: $140,607.28
These are just a couple of items you want to consider before deciding to withdraw early from your 401k. Run both the numbers on taxes and long term impact if you are considering it. It could have a huge impact on you down the road.