401(k) plans are designated as tax-efficient retirement savings vehicles, with the idea that funds contributed will be used only to fund retirement. Following the rules of your 401(k) means you can enjoy pre-tax contributions and tax-deferred growth that maximize your assets later in life. That said, instances can come up where you may wonder how easily you could access those funds in a pinch. Individuals thinking about early withdrawals from their 401(k) accounts should know that this process can severely limit the growth of your portfolio and subjects you to penalties. Here we examine what those penalties are and under what circumstances an individual would consider an early withdrawal from their retirement account.
10% Tax Levied on Early 401(k) Withdrawals
To encourage the long-term participation in 401(k) retirement plans, the IRS levies a 10% penalty to distributions taken before age 59 ½ unless the distributions meet certain criteria. While a fine of 10% does not sound severe, this is not the only tax paid on withdrawals.
Assume you have a traditional 401(k) plan and your income tax rate is 25%. A withdrawal of $10,000 before age 59½ would be subject to a 10% penalty in addition to the 25% income tax you would normally incur on your income.
Calculating an Early Withdrawal:
|Penalty Amount||$1,000 (10,000 x .10)|
Income Tax Amount
|$2,500 (10,000 x .25)|
|Total Federal Taxes Paid||$3,500|
|Net Withdrawal Amount||$6,500|
What started as a nice withdrawal amount of $10,000 was reduced by a full 35% thanks to the IRS penalty and normal income tax. Further, the example above does not consider state tax levied on an individual’s income, so the resulting net withdrawal amount can decrease even further depending on your state’s income tax rate.
Another item to consider is your employer’s vesting schedule. Thanks to vesting, you may not actually own all the assets in your 401(k) – at least not initially. Vesting refers to the degree of ownership an employee has in their retirement account. If you are the sole contributor to your 401(k), then you are 100% vested – entitled to the full account balance. However, many workers participating in their company’s retirement plan enjoy employer matching benefits. In these programs, the company matches a percentage (or sometimes all) of an employee’s 401(k) contribution, but these employer contributions may be subject to a “vesting schedule”.
A vesting schedule is the provision of a 401(k) that stipulates the number of service years required to attain full ownership of an account. Many employers use vesting schedules to encourage employee retention because they mandate a certain number of years of service before employees are entitled to the full amount of funds contributed by the employer.
Of the different vesting schemes, “cliff vesting” is when an employee is 0% vested for a stated number of years, after which they become fully vested. “Graduated vesting” means that the employee becomes progressively more vested after each year of service, eventually becoming fully vested.
Vesting Example: Assume you’ve been working at your company for 3 years and are gradually assigned 10% vesting for each year of service after the first year. At this point in your tenure at the company you would be entitled to only 20% of your employer’s contribution. If you were to switch employers before you become fully vested, you will lose out on the non-vested contributions.
Additional Early Withdrawal Considerations
Beside the obvious tax penalties and potential vesting limitations on an early 401(k) withdrawal, a decision to take money prior to the mandated age should also consider opportunity cost. The idea of opportunity cost essentially means the consideration of what other potential gains you may be losing out on when one alternative is chosen. In this case, money withdrawn from an investment means losing potential future investment growth. This should be a significant consideration due to the compounding interest of investments. This is in full effect if you are in your prime working years and are maximizing contributions. Given the annual contribution limits on 401(k) retirement accounts, it becomes nearly impossible to make up the lost earnings after an early withdrawal. Another item to note, even if you can only make small contributions, beginning at age 25 these small contributions may grow larger with compounded interest by the time you reach retirement than starting to make large contributions when you are 40.
Exceptions to 401(k) Withdrawal Penalties
This whole discussion carries a few caveats. There are exceptions to the 10% penalty on early distributions from your traditional 401(k) account that are intended to alleviate financial losses under certain situations. The IRS lists the following as exemptions for withdrawals prior to reaching age 59½:
- Original account holder dies and distributions are made to the beneficiary
- You become disabled
- You terminate employment and are at least 55 years old
- You withdraw an amount less than is allowable as a medical expense deduction
- You begin substantially equal periodic payments (Rule 72(t))
- Your withdrawal is related to a qualified domestic relations order1
Alternatives to 401(k) Withdrawals: Loans
Due to the tax penalties and potential vesting implications, early withdrawals from a traditional 401(k) account are generally only advised as a last resort. While there are circumstances in which unexpected hardship requires immediate financial relief, taking money from your retirement investment can potentially jeopardize your retirement safety net. Rather than withdrawing money directly from your retirement account, there is the possibility to take a loan against your 401(k). The IRS offers 401(k) plan participants the option to take out a loan from their account up to an amount of $50,000, or 50% of their vested account balance, whichever is smaller. Repayments generally must occur over the subsequent 5 years and interest rates on the loan, set by the plan sponsor, must be “reasonable”. Although it is best to not tamper with your 401(k) before retirement, taking out a loan against your account has a lower impact on your retirement readiness than outright withdrawing the same sum.
As with any large financial decision, it is always best to consult a trusted financial advisor. They are best prepared to walk you through the details of an early withdrawal and explain the implications to your particular situation – both the immediate tax costs and the opportunity cost of your long-term investment.