Technically, that money is yours, but the government still gets a say in how you use it.
Everyone knows that your retirement savings are meant to be used after you quit the workforce. But it can look awfully tempting when you’re in a financial bind. You’re technically free to take that money out anytime and spend it on whatever you’d like.
But that doesn’t mean a withdrawal is your best move. Below, we’ll look at what happens when you make an early 401(k) withdrawal, when you may want to do so, and what your alternatives are.
What happens when you make an early 401(k) withdrawal?
The government tries to discourage you from making early 401(k) withdrawals by charging a 10% early withdrawal penalty if you’re under age 59 1/2 at the time. There are some exceptions for this if you’re using the money for things like higher education or large medical expenses.
But even if you avoid the penalty, you’ll still have to pay taxes on your withdrawal unless you’re only taking out Roth 401(k) contributions. This could result in a smaller tax refund or even a higher tax bill this year.
But the bigger problem is the effect early withdrawals have on your retirement savings. You’ll have to save even more going forward to make up for the withdrawal you took. And if you need the money quickly, you might be forced to sell when your investments are down, which could set you back even further.
What about 401(k) loans?
A 401(k) loan is a slightly better alternative for those who need money in a pinch, assuming the plan allows it. This is where you borrow money from your 401(k) and pay it back — along with interest — over time.
You can take out one of these loans regardless of your credit rating. But if you fail to pay back what you owe within the required time frame, the government treats the outstanding balance just like it would an early withdrawal: You’ll pay taxes on it and a penalty if you’re under 59 1/2.
It’s usually best to avoid these loans if you aren’t confident in your ability to pay back what you owe in a timely fashion or if you plan to leave your employer soon. This can cause the full outstanding balance of the loan to come due at once.
Should you ever take money out of your 401(k) early?
You have to weigh the costs and benefits of taking an early 401(k) withdrawal to decide if it’s the right move for you. But before you make that call, explore all of the options available to you.
Here are some other approaches you can try to get the money you need:
- Tap your emergency fund: If you have an emergency fund, use this money rather than your 401(k). You won’t have to worry about any taxes or penalties this way and it won’t slow the growth of your retirement savings.
- Save up over time: When you don’t need to make a purchase immediately, try saving up for it over time. If you’re struggling to do this and saving for retirement, you could always reduce your 401(k) contributions. This isn’t ideal but will help you avoid taxes and penalties due to an early 401(k) withdrawal.
- Explore other types of loans: You may be able to get the money you need by seeking out a traditional loan. Try a mortgage, if you’re buying a home, or an auto loan for a car purchase. These loans will have fees and you’ll owe interest to the lender, but you’ll be able to leave your retirement savings untouched.
There might be a situation where you need money quickly and you don’t have an emergency fund and can’t qualify for a loan. In this case, taking money out of your 401(k) might be a better option than losing the roof over your head, for example. But consider it a method of last resort.
If you do have to take money out of your 401(k) ahead of retirement, revisit your retirement savings strategy. Try to boost your future contributions or consider remaining in the workforce a little longer so you have time to save what you need for a comfortable lifestyle.
