Do Not Cash Out Your 401k

What happens when you cash out of your 401(k)? If you are planning to cash out of your 401k, there are several consequences that you’ll have to consider — and these are expensive consequences. In general, it is a good idea to avoid this and here are the 4 reasons why cashing out is a bad idea.

1. Income Taxes

First, you’ll have to pay the federal income tax at your marginal tax rate for the entire withdrawal amount.  Depending on your tax bracket, you could pay anywhere from 10% to 35% on the amount withdrawn.  Let’s say your regular taxable income for the year is $50,000.  You went ahead and took out $20,000 from your 401(k).  You will have to pay 25% in federal income tax, or $5,000.

Depending on your city and state laws, your withdrawal can be taxable to the city and state also.  Let’s assume this is about 10%, that’s another $2,000.

You are now left with $13,000 out of the original $20,000 early withdrawal.

2. Early Withdrawal Penalty

If you are younger than 59½, you will have to pay another 10% on the withdrawal amount — this is called the early withdrawal penalty.  Following the example above, that is another $2,000 less for you, and you are left with $11,000.

3. Redemption Fees

Depending on your investment options, you may be assessed redemption fees.  For example, some of our investment options — i.e., international funds and small-cap funds — assess 1% penalty on shares purchased and redeemed within 180 days.

4. Opportunity Cost

I believe that in the long-term the stock market can sustain an 8% annual growth rate.  Following the example above, taking out $20,000 could translate to $186,000 over the course of 30 years. That is a huge opportunity cost for the resulting $11,000 cash that you get to keep now.

What Happens When You Stop Contributing to Your 401(k)

If you are considering withdrawing money from your 401(k), it is likely that you are also considering not contributing any longer (or at least for a long while). Here are 2 reasons why not contributing to your 401(k) is also a bad idea.

1. Company Match

Many companies match 50 cents on the dollar up to 6% on 401(k) contributions.  If you make $50,000 a year and you contribute 10% of your salary, this means you contribute $5,000 a year and your company matches $1,500 a year. If you stop your contributions, you are essentially throwing away $1,500 of free money…that is a damn shame.

2. Tax Deduction

Additionally, your contributions are deductible against federal, state, and city income taxes each year.  Assuming the combined taxes total 35%, you are potentially giving up $1,750 in tax savings.

What Should You Do with Your 401(k)

Only you could answer that question because you know your financial situation, risk tolerance level, and time horizon the best.

Have you considered withdrawing money from your 401(k) before? What did you consider before making the decision?

11 thoughts on “Do Not Cash Out Your 401k”

  1. Recently I saw a newletter published by a local bank that said the safest place for your money (not just short-term funds) is in “guaranteed” investments. Their catch phrase was “return of investment is more important now than return on investment.”

    Keep plugging away on your 401k and put your contributions into a diversified mix of ownership positions. The wealth building process is like a yo-yo climbing a flight of stairs. Expect to lose money 2 to 3 times per decade and once in awhile (like now) there will be a big drop. But every bear market has been followed by a bull market.

    The Fed is pumping out money like there is no tomorrow – http://research.stlouisfed.org...../page3.pdf. Eventually this will trigger a major surge in the stock market. Owners of tangible assets (not dollar-based assets) will be the winners at the end of this shakeout.

  2. When the market is as down as much as it is, long term savings are almost guarenteed to generate pretty impressive long term returns. If you have a decently long time horizon to retirement (10 years or more), stoping retirement investing or pulling money is exactly the wrong type of response.

  3. I totally agree. If you cash out now you are just locking in loses. Like Buffet has said, be fearful when others are greedy and greedy when others are fearful. Right now everyone seems to be fearful. It is a buying opportunity.

  4. @Shadox — I agree with your assessment. 40% discount makes for a terrific buying opportunity.

    @Tom — Locking in your losses is also something that I should mention in my article. Excellent add.

  5. I think now is the time to stop contributing to 401K if you have already got your employer match or lower or raise it to only so much that you capture the match..

    Remember Lehman Brother was steal at 40 bucks, then at 30 then at 20, 10, 5 , 2 and now worthless…so any amount of investing would have given you ZERO…

  6. Telling people that “Now is not the time to cash out your 401K” or “Now is the time to increase your 401K contributions” Is all well and good if you are rich or have alot in your 401K, But I have lost almost 50% of my 401K due to the bad economy and crap stock market. Forcasters are predicting that the economy and market will be bad for at least another 1-2 years. At the rate I have been losing money, my 401K will be gone in another 1-1/2 years. I will take mine out now and take the tax hit. Taking a tax hit on my money and having it in my hand is much better than waiting and having nothing.

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