Dumb Money: Early 401k Withdrawals

by Kevin on September 13, 2010

The economy is still struggling to get going. While jobless claims recently fell more than expected there were still 451,000 initial applications for unemployment.

Millions of Americans are still unemployed and continue to find consistent work. (Still wondering why you’re unemployed? Check out 7 reasons why you’re still unemployed.)

Being unemployed, naturally, causes a lot of financial strife. Folks are burning through emergency funds, the rest of their savings, their kid’s college education fund… anything they can get their hands on to survive.

It is truly desperate times for a lot of people. And desperate times call for desperate measures.

Raiding the 401k Account

CNN recently published an article highlighting the increase in 401k hardship withdrawals.

Again desperate times call for desperate measures, but I wonder if the people making these hardship withdrawals truly understand the costs behind their choices. We’ll get into the costs in a moment, but let me just say they are substantial!

If you have no other option, then you have no other option. If you’ve tapped out your liquid savings, sold the second vehicle and are sharing a ride to work, you’ve taken the much smaller early withdrawal penalty on all your CDs, if you are absolutely maxed out and have no other options to have a place to live… then you have no other choice. No one should judge you if you’re backed into a corner with no other options.

Just make sure you’re making an informed decision. Read on.

Reasons to Avoid Early 401k Withdrawals

Let’s say you’ve saved up $50,000 in your 401k. You hate to do it, but it’s time to smash the emergency glass and grab some of that cash.

Now you’re smart. Your bare bones monthly costs are $2,000. You don’t need to pull out all $50,000. You’re only looking to give yourself 5 months of breathing room. Time to find a job. Time to get stabilized. You decide to withdraw $10,000 early.

Fees

Right off the top the government requires you to pay a 10% fee on any early withdrawal amount. (This is assuming you don’t qualify for certain no-penalty withdrawals which we will cover in another article in the future.)

Your $10,000 withdrawal is now $9,000 for you and $1,000 for the government.

Taxes

Now paying 10% to get access to money that could stabilize you financially isn’t too bad. So the fee the government charges, while not exactly fun to experience, could be a lot worse.

That’s where your favorite thing, taxes, steps in.

Since your initial 401k contributions were deductible on your taxes you must now pay taxes on the money coming back out of the account.

So this cost will vary based on your income, but let’s say you’re in the 25% tax bracket. That’s another $2,500 off the $10,000 hardship withdrawal you’re making.

Your Net Withdrawal

You started with planning to use $10,000 to pay for 5 months of $2,000 worth of expenses.

That $10,000 has been cut from taxes and fees by $3,500 to $6,500. You’re left with 65% of what you had planned to start with. It’ll also only last you 3.25 months if you used it as originally planned. (In fact you need to withdraw $15,384.62 to net $10,000.)

Of course your individual situation could be better or worse depending on your tax bracket. If you’ve been unemployed then there’s a chance your tax bracket would be really low this year — maybe you’d be in the 15% tax bracket. That’s still $1,500 off that $10,000 withdrawal.

Don’t Forget Lost Growth

If that 35% cut out of your withdrawal wasn’t painful enough then let me remind you that you’ll be missing out on the investment growth of the withdrawal.

Let’s assume you’re 30 and plan to retire at 65. If you left the $10,000 in your 401k and earned 7% per year that $10,000 would grow to $106,766.

Is it worth it? It’s a mighty large financial hit to take.

But if you truly have no other option, well, at least you know what it is going to cost you.

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Darwin’s Weekly Reads – Gold on Fire Edition
September 17, 2010 at 6:36 pm

{ 6 comments… read them below or add one }

Ken September 13, 2010 at 1:59 pm

Great info here that the average Joe doesn’t consider before pulling that money out. Good stuff.

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Kevin September 15, 2010 at 6:58 pm

It really is a bad deal… 35-45% of the money disappears in taxes and fees. Ouch.

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Jimbo September 13, 2010 at 2:43 pm

How about pulling from a ROTH? As bad? Worse? Better?

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Kevin September 15, 2010 at 6:57 pm

I’ll go through this more in the future. It will probably be next Monday or Thursday that I’ll get it scheduled. Make sure you come back (or subscribe via email or RSS — check the top right of the page for free subscription options.)

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Golfing Girl September 14, 2010 at 8:31 am

When we were stuck with a home that wouldn’t sell, my husband took out a loan against his 401K–granted the terms stated that you couldn’t make extra payments-instead you had to either keep paying the set payment or pay it off in a lump sum (which we eventually did when the house sold). This was a MUCH better option than cashing out part of the 401K. Granted, he had to prove income to get the loan so this might not work for those where both spouses or a single person is unemployed.

I also second the Roth…

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melogos October 3, 2010 at 7:22 am

Dipping into one’s IRA or 401(k) is like the guy who borrows from the funds he has set aside for his house payment, his rent money, or his car payment. While he enjoys spending the money on a worthy cause…when he is ready to pay his house payment he misses a payment and brings both his mortgage and credit record in jeopardy. At http://www.christianretirement.com I read a helpful article about paying oneself first. I hope it helps someone else.

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