Early 401(k) Withdrawals at a Young Age: What You Need to Know
About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C. area, that works with clients virtually across the country. Lamar's work with his clients focuses on budgeting, employee benefits, paying down debt, buying their first home, and investing. Lamar is the Founder of Dream Financial Planning, a virtual financial planning firm specifically designed to help young professionals and minorities take control of their finances and fulfill their dreams. Feel free to schedule a complimentary consultation to learn how we use the The DREAM Financial Planning Process ™ to help our clients achieve their goals.
Are you contributing to your employer's 401(k) plan? Taking advantage of this retirement savings vehicle is a no-brainer when it comes to having an easy way to save money for retirement each month. According to the Bureau of Labor Statistics, the average 401(k) match nets out to about 4 percent,1 which may initially not sound like much, but with compounding interest, this amount can quickly add up as you contribute funds throughout your career.
Only 40% of employees contribute to a 401k
Census Bureau research has found that about 80 percent of Americans are eligible to contribute to a 401(k) plan. However, only about 40 percent of employees actually do.2 Not taking advantage of a 401(k) match is akin to leaving "free money" on the table. This low participation could be due to a lack of employee education and awareness of 401(k) plan benefits. For those unsure about the rules and stipulations surrounding 401(k) plans, consider hiring a financial advisor who can walk you through each detail, so you're well-versed in the vehicle's requirements.
According to E-Trade Financial, "nearly 60 percent of investors ages 18 to 34 say they already have taken money from their retirement account.”3 This number is nearly double what it was in 2015 and is due, in part, to millennials carrying most of the $1.4 trillion in student loan debt when compared to older generations.3 Many millennials have wages that are lower than what their parents were making when they were in their 20s and 30s on an inflation-adjusted basis. If you have a decent amount of money saved up, it can be tempting to withdraw your 401(k) funds sooner than initially planned. However, there are a variety of reasons why doing so will not benefit you in the long-run.
Overview of 401(k) Plans
Most of the following discussion is based on traditional 401k plans, which is what most of the clients we work with have. I will discuss Roth 401ks at the end of this blog post.
Two benefits of a 401(k) plan include tax-deductible and tax-deferred contributions. This means that you'll not only save on taxes but that you also won't have to pay any taxes until you withdraw your money. However, you can only take advantage of these benefits if you follow specific 401(k) plan rules.
In most cases, any 401(k) withdrawal you make is going to be taxable as ordinary income; With most 401(k) plans, you're not expected to withdraw these funds until you are at least 59½. If you make an early withdrawal, you'll incur a 10 percent early distribution penalty on top of paying ordinary income tax on the amount you take out. And that's only one of the many disadvantages of withdrawing from your 401(k) plan early.
Disadvantages of Withdrawing 401(k) Funds Early
Withdrawing your 401(k) funds before you're 59½ can practically eliminate the main benefits of a 401(k) plan: tax deductions. This is caused by a number of penalties attached to early withdrawals. As mentioned previously, any withdrawal amount is considered to be taxable ordinary income, which means you'll be losing a significant amount of your savings simply by the timing of your withdrawal.
In some cases, you may be in a higher tax bracket when you withdraw the money than when you're in retirement, which can significantly increase the amount of taxes you'll have to pay once you do withdraw. Additionally, by taking your money out early, you're preventing it from growing and multiplying, which is one of the main reasons to contribute to a 401(k) plan. While the reward may initially seem worth it, by the time you get to retirement, these funds will most likely be missed. Ultimately, the longer your money sits in a 401(k), the more it will compound.
A $10,000 withdrawal as 30 year old could cost you over $280,000 by the time you retire.
We always work with our clients to establish a solid foundation of personal finance fundamentals. Saving early and often, even a small amount, is crucial to long term success. When working with clients and taking them through the Dream Financial Planning Process ™, we work to optimize their budget and establish an emergency fund so they can handle unexpected expenses. We never recommend withdrawing money from a 401k unless it's a last resort or to possibly buy a home.
For example, let's say you're a 30-year-old that is contemplating withdrawing $10,000 from your 401k or IRA (Individual Retirement Account). If you don't qualify for an exemption that $10,000 is going to be approximately $7,000 after taxes and penalties depending on your tax rate.
You plan to retire at 65 years old, so you have a 35-year time horizon. $10,000 invested for 35 years, earning 10% per year, which happens to be the long-term return of the stock market as defined by the S&P 500 index, comes out to approximately $281,000.
Early Withdrawal Exceptions
While there are exceptions to early withdrawal, it's important to note that your withdrawal will still be counted as taxable ordinary income. However, if you meet one or more of the below exceptions, you will not have a 10 percent penalty to pay in addition to the taxes.
As always, make sure to read your own individual plan's requirements, as not every 401(k) plan follows the same rules.
You may be able to withdraw from your 401(k) early with minimal consequences if:
- You have a disability.
- You were fired from your job when you were 55 or older.
- You have significant medical expenses.
- You have a qualified domestic relations order.
A Roth 401k is a retirement plan where you make contributions on an after-tax basis compared to a traditional 401k, where contributions are made on a pre-tax basis. The contribution limit is $19,000 for 2019 or $25,000 if you are age 50 or older.
The downside of Roth 401(k) contributions is they don't reduce your current taxable income. However, the primary advantage of a Roth 401k is that earnings and employee contributions are tax and penalty-free on withdrawal if the account owner is at least 59½ and has held their Roth 401(k) account for at least five years. The employer match of Roth 401(k) contributions will be taxed as ordinary income on withdrawal. Withdrawals can also be taken penalty-free if the account owner becomes disabled or by a beneficiary of the Roth 401(k) after the account owner's death.
Dream Financial Planning Process ™
Whether you're managing student loan debt, starting a business, or considering buying a house, the DREAM Financial Planning Process™ is tailored to your unique needs and goals as a young professional.
This process is catered specifically to those who have recently graduated from college or just recently began working at their first full-time job; this process focuses more on short-term goals while you grow and evolve in your personal and professional life. If you're looking for guidance on budgeting, student loans, rebalancing your 401k, or managing investments, please feel free to contact us for a
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