Ask Carrie: Why is taking money early from your 401(k) such a big deal?
My older sister always tells me not to touch my 401(k) before I retire, but I see it as a source of ready cash. What do you think?
I hate to take sides in a family disagreement, but for the most part, your sister is right. The big deal is that by tapping into your 401(k) balance early, you could be hit with significant penalties and taxes. That’s the immediate concern. Then you have to think about the future. If you take the cash now, not only will you have that much less when you retire—you’ll also lose any potential earnings.
Now when times are tough and you have no other options, your 401(k) can help you out of a financial jam. But if you don’t really need the money, there are a several reasons why it’s better to keep a hands-off attitude.
First and foremost is how much you stand to lose upfront. If you have a traditional 401(k), you don’t pay income taxes on contributions or earnings but you’ll owe taxes at your ordinary rate once you make a withdrawal. With a Roth 401(k), you don’t get the up-front deduction, but earnings grow tax-free and withdrawals after age 59½ are tax-free provided you’ve held the account for five years. With either 401(k), you’ll likely be slapped with a 10% penalty if you take a withdrawal before age 59½.
So let’s say you’re age 50 and in the 25% tax bracket. You’ve run up some hefty credit card bills and you decide to withdraw $20,000 from your traditional 401(k) to pay them off. First, subtract the $5,000 you’d owe in income taxes. Then subtract an additional $2,000 in penalties. Right away, you’re down $7,000 or 35%. That’s a pretty hefty price for taking your own money.
Next consider the potential earnings you could be losing. For example, if that $20,000 were to grow at an annual interest rate of 5% for another 15 years, you’d have over $41,500—more than double your money!
A 401(k) loan is another possibility. You won’t pay penalties or taxes, but you will pay interest. That interest goes back into your own account, so in a sense, you’re paying it to yourself. But no matter what, you have to repay the loan—and on time. If you don’t, it’s considered a taxable distribution with a possible 10% early withdrawal penalty. The maximum loan term is five years unless you’re borrowing for a first-time home purchase. The specific terms can vary by plan but at the very least, you have to make quarterly payments.
Then there’s the matter of job security. If you lose your job or change jobs, in most cases, you have to pay back the entire loan within 60 days of termination. If you can’t, there are those ever-present penalties and taxes. So the real question is: If you need the loan in the first place, where are you going to find the money to pay it back?
Ultimately, leaving your 401(k) intact makes the most sense unless you have an urgent financial need. The longer you let it grow, the more you’ll have and the more secure you’ll feel down the road. In fact, don’t just watch it grow: Keep adding to it regularly—at least enough to qualify for any company match.
And while you’re thinking about saving, focus on building an emergency fund of at least three to six months’ worth of money for necessary expenses. Then when you need extra cash, you’ll have it at the ready.
This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. COPYRIGHT® 2013 CHARLES SCHWAB & CO., INC. MEMBER SIPC. (1113-7663)