Disadvantages Of Closing Your 401k
Whether you should cash out your 401k before turning 59 ½ is another story. The biggest disadvantage is the penalty the IRS applies on early withdrawals.
First, you must pay an immediate 10% penalty on the amount withdrawn. Later, you must include the amount withdrawn as income when you file taxes. Even further down the road, there is severe damage on the long-term earning potential of your 401k account.
So, lets say at age 40, you have $50,000 in your 401k and decide you want to cash out $25,000 of it. For starters, the 10% early withdrawal penalty of $2,500 means you only get $22,500.
Later, the $25,000 is added to your taxable income for that year. If you were single and making $75,000, you would be in the 22% tax bracket. Add $25,000 to that and now youre being taxed on $100,000 income, which means youre in the 24% tax bracket. That means youre paying an extra $6,000 in taxes.
So, youre net for early withdrawal is just $16,500. In other words, it cost you $8,500 to withdraw $25,000.
Beyond that, you reduced the earning potential of your 401k account by $25,000. Measured over 25 years, the cost to your bottom line would be around $100,000. That is an even bigger disadvantage.
Making The Numbers Add Up
Put simply, to cash out all or part of a 401 retirement fund without being subject to penalties, you must reach the age of 59½, pass away, become disabled, or undergo some sort of financial hardship . Whatever the circumstance though, if you choose to withdraw funds early, you should prepare yourself for the possibility of funds becoming subject to income tax, and early distributions being subjected to additional fees or penalties. Be aware as well: Any funds in a 401 plan are protected in the event of bankruptcy, and creditors cannot seize them. Once removed, your money will no longer receive these protections, which may expose you to hidden expenses at a later date.
Here’s How To Avoid Penalties If You Tap Into Your Retirement Savings
If you find yourself unemployed, it’s natural to think about accessing 401 funds to make ends meet. Here’s a recap on how 401 accounts work and the rules governing withdrawals, including new rules helping those impacted by economic downturns and pandemics.
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How To Take Money Out Of Your 401
There are many different ways to take money out of a 401, including:
- Withdrawing money when you retire: These are withdrawals made after age 59 1/2.
- Making an early withdrawal: These are withdrawals made prior to age 59 1/2. You may be subject to a 10% penalty unless your situation qualifies as an exception.
- Making a hardship withdrawal: These are early withdrawals made because of immediate financial need. You may be still be penalized for them.
- Taking out a 401 loan: You can borrow against your 401 and will not incur penalties as long as you repay the loan on schedule.
- Rolling over a 401: If you leave your job, you can move your 401 into another 401 or IRA without penalty as long as the funds are moved over within 60 days of your distribution.
Start Earning More For A Better Financial Future
The answer to How much should I have in my 401k? is an important one but its not the only way to ensure your financial future.
We are going to let you in on a little secret. It is one that has helped thousands of people live their Rich Life:
Theres a limit to how much you can save, but theres no limit to how much money you can earn.
Many people dont understand this and because of that, theyre content with contributing very little to their retirement accounts. When they actually retire, theyre surprised when their nest egg is a lot smaller than they thought and they have to get a job as a Walmart greeter to pay for their condo.
If you realize that your earning potential is LIMITLESS, you can truly get started working toward living a Rich Life today.
We recommend three ways to start earning more money:
1. Negotiate a salary raise. 99% of people are content with not asking for a salary raise. So if you are willing to negotiate, that puts you in the 1% and showcases to your boss that youre a Top Performer willing to work hard for more money.
2. Start a side hustle. One of my favorite money-making tactics is starting your own side hustle. We all have skills. Why not leverage those skills to start earning more money in your free time?
We want to help you get started on one of these tactics today: Starting a side hustle.
Thats why we want to offer you my Ultimate Guide to Making Money.
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Weighing Pros And Cons
Before you determine whether to borrow from your 401 account, consider the following advantages and drawbacks to this decision.
On the plus side:
- You usually dont have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since youre borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isnt invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
CAUTION: Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If thats the case, youll probably have to repay the entire balance within 90 days of your departure. If you dont repay, youre in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if youre younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
Debt Relief Without Closing My 401k
Before borrowing money from your retirement account, consider other options like nonprofit credit counseling or a home equity loan. You may be able to access a nonprofit debt management plan where your payments are consolidated, without having to take out a new loan. A credit counselor can review your income and expenses and see if you qualify for debt consolidation without taking out a new loan.
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Withdrawing From A Roth 401k
Most 401k plans involve pre-tax contributions, but some allow for Roth contributions, meaning those made after taxes already have been paid.
The benefit of making a Roth contribution to your 401k plan is that you already have paid the taxes and, when you withdraw the money, there is no tax on the amount gained as long as you meet these two provisions:
- You withdraw the money at least five years after your first contribution to the Roth account
- You are older than 59 ½ or you became disabled or the money goes to someone who is the beneficiary after your death
Convert To An Ira And Keep Contributing
You cannot contribute to a 401 after you leave your job, so if you want to continue adding money to your retirement funds, youll need to roll over your account into an IRA. Previously, you could contribute to a Roth IRA indefinitely but could not contribute to a traditional IRA after age 70½. However, under the new Setting Every Community Up for Retirement Enhancement Act, you can now contribute to a traditional IRA for as long as you like.
Keep in mind that you can only contribute earned income, not gross income, to either type of IRA, so this strategy will only work if you have not retired completely and still earn taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment, as the IRS puts it. You cant contribute money earned from either investments or your Social Security check, though certain types of alimony payments may qualify.
To execute a rollover of your 401, you can ask your plan administrator to distribute your savings directly to a new or existing IRA. Alternatively, you can elect to take the distribution yourself. However, in this case, you must deposit the funds into your IRA within 60 days to avoid paying taxes on the income.
Traditional 401 accounts can be rolled over into either a traditional IRA or a Roth IRA, whereas designated Roth 401 accounts must be rolled over into a Roth IRA.
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Making A Choice For Your 401
Maybe youve switched jobs to take on new challenges. Perhaps youre thinking about changing career paths for something more rewarding. Or maybe youre finally getting ready to retire.
We understand when your life changes, other things may change toolike your goals for retirement. Well help you consider your options for your 401 accounts from past jobs, so you can feel confident youre on track for the future you want.
Your Retirement Money Is Safe From Creditors
Did you know that money saved in a retirement account is safe from creditors? If you are sued by debt collectors or declare bankruptcy, your 401k and IRAs cannot be liquidated by creditors to satisfy bills you owe. If youre having problems managing your debt, its better to seek alternatives other than an early withdrawal, which will also come with a high penalty.
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Move Your Retirement Savings Directly Into Your Current Or New Qrp If The Qrp Allows
If you are at a new company, moving your retirement savings to this employers QRP may be an option. This option may be appropriate if youd like to keep your retirement savings in one account, and if youre satisfied with investment choices offered by this plan. This alternative shares many of the same features and considerations of leaving your money with your former employer.
- Option not available to everyone .
- Waiting period for enrolling in new employers plan may apply.
- New employers plan will determine:
- When and how you access your retirement savings.
- Which investment options are available to you.
Note: If you choose this option, make sure your new employer will accept a transfer from your old plan, and then contact the new plan provider to get the process started. Also, remember to periodically review your investments, and carefully track associated paperwork and documents. There may be no RMDs from your QRP where you are currently employed, as long as the plan allows and you are not a 5% or more owner of that company.
Three Consequences Of A 401 Early Withdrawal Or Cashing Out A 401
Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401 early withdrawal for taxes. So if you withdraw $10,000 from your 401 at age 40, you may get only about $8,000. Keep in mind that you might get some of this back in the form of a tax refund at tax time if your withholding exceeds your actual tax liability.
The IRS will penalize you. If you withdraw money from your 401 before youre 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government $1,000 of that $10,000 withdrawal. Between the taxes and penalty, your immediate take-home total could be as low as $7,000 from your original $10,000.
It may mean less money for your future. That may be especially true if the market is down when you make the early withdrawal. If you’re pulling funds out, it can severely impact your ability to participate in a rebound, and then your entire retirement plan is offset, says Adam Harding, a certified financial planner in Scottsdale, Arizona.
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Talk To Hr About Enrolling In Your 401
If you’re interested in opening a 401, talk with your employer to learn about how your company’s plan works. Some employers automatically enroll employees and withhold a default amount of their paychecks, which you can change yourself at any time. You can also opt to stop contributing to the plan if you’re not interested in doing so right now.
Other companies require participants to declare their desire to participate in the 401. You’ll have to fill out paperwork saying that you’d like to contribute to the plan and how much money you’d like to set aside initially. You can always change this later.
You’ll also need to choose your beneficiary — the person you’d like to inherit your 401 if you die — when you sign up. Usually you choose a primary beneficiary and a secondary, or contingent, beneficiary who will inherit the 401 if the primary beneficiary is deceased or doesn’t want the money.
Options For Borrowing From A 401 While Still Working
If youre still in the workforce and need to access your 401 funds for one reason or another, you may still have options. These pre-retirement withdrawal options include in-service distributions, hardship withdrawals, and plan loans.
In-service distributions allow you to withdraw your vested money before retirement and are sometimes referred to as an early retirement option in the plan. This is generally allowed at age 59 ½ because distributions of your 401 deferrals before that age are subject to a 10 percent penalty tax.
Hardship distributions are allowed for special reasons such as medical care, purchase of your home, tuition, funeral expenses, payments to prevent eviction, and damage to your principal residence. The distribution is limited to the amount you need, and your employer will need to see some proof of the hardship. Hardship distributions are subject to income tax and the 10 percent penalty tax for distribution before 59 ½.
Plan loans occur when you borrow money from your 401 balance, but the amount you can withdraw is limited to the half of your vested balance and cannot be more than $50,000. The loan will have to be paid back to the plan with interest, and the loan period cannot exceed five years in most cases. That being said, loans taken out for principal residence can be longer than five years.
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How Are 401 Withdrawals Taxed
If a rollover-eligible withdrawal is made to you in cash, the taxable amount will be reduced by 20% Federal income tax withholding. Non-rollover eligible withdrawals are subject to 10% withholding unless you elect a lower amount. State tax withholding may also apply depending upon your state of residence.
However, your ultimate tax liability on a 401 withdrawal will be based on your Federal income and state tax rates. That means you will receive a tax refund if your actual tax rate is lower than the withholding rate or owe more taxes if its higher.
If a 401 withdrawal is made to you before you reach age 59½, the taxable amount will be subject to a 10% premature withdrawal penalty unless an exception applies. This penalty is meant to discourage you from withdrawing your 401 savings before you need it for retirement. You can avoid the 10% penalty under the following circumstances:
- You terminate service with your employer during or after the calendar year in which you reach age 55
- You are the beneficiary of the death distribution
- You have a qualifying disability
- You are the beneficiary of a Qualified Domestic Relations Order
- Your distribution is due to a plan testing failure
A full list of the exceptions to the 10% premature distribution penalty can be found on the IRS website.
Reinvest Extra Money In An Indexed Fund
You can provide an additional layer of protection by automatically reinvesting extra cash in an indexed fund.
For instance, you can invest dividends or bank account interest in an S& P 500 indexed fund. Thus, you could lock in a 10% growth rate for at least part of your money.
Therefore, you can make compound interest part of your 401K and ensure that some of your money is growing. Moreover, you can enhance compound interest by combining it with the S& P 500, which has a long history of growth.
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Impact On Student Debt
The SECURE Act also allows people to withdraw up to $10,000 during their lifetime from their 529 plans, tax-free, in order to pay off their student loan debt. Originally, 529 plans were strictly for post-secondary education expenses, but that has been expanded to include K-12 expenses.
Under the SECURE Act, 529 funds can be used to pay off college debt. That said, not all states may allow the student loan benefit to come out tax-free at the state level.
What Are Alternatives
Because withdrawing or borrowing from your 401 has drawbacks, it’s a good idea to look at other options and only use your retirement savings as a last resort.
A few possible alternatives to consider include:
- Using HSA savings, if it’s a qualified medical expense
- Tapping into emergency savings
- Transferring higher interest credit card balances to a new lower interest credit card
- Using other non-retirement savings, such as checking, savings, and brokerage accounts
- Using a home equity line of credit or a personal loan3
- Withdrawing from a Roth IRAthese withdrawals are usually tax- and penalty-free
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