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 Depending on your tax bracket, you could pay anywhere from 10% to 35% on the amount withdrawn.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.
- In general, you should contribute as much as you can to your 401(k) — at the minimum, you should make sure you capture the maximum company matching contributions as you could.
- If you want to make a withdrawal because you need money, then consider other loan options. Also, borrowing money from peer-to-peer lending sites is very safe and dead easy.
- If you want to make a withdrawal because you are nervous about the market, then learn about asset allocation and build an investment portfolio that matches your ability, time horizon, and risk tolerance level.
Have you considered withdrawing money from your 401(k) before? What did you consider before making the decision?
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.