America's major stock market indexes, including the Dow Jones Industrial, S&P 500, Nasdaq Composite and Nasdaq 100, all hit record highs on July 7, 2021.1 For some investors, it might be tempting to tap into your 401(k) to help pay down debts, purchase a home or take a once-in-a-lifetime vacation. However, doing so could seriously cost you, both now and in the future. Below, we'll discuss two of the main disadvantages of cashing out a 401(k) early.
Taxes and Penalties
Unless your 401(k) withdrawal meets the requirements of a few exceptions permitted by the IRS, such as paying federal taxes owed after the IRS levies the 401(k) account or becoming totally and permanently disabled, you'll pay a 10 percent penalty plus any applicable taxes on the withdrawal.2 Any amount withdrawn before you reach age 59 1/2 will be treated as ordinary income, potentially putting you in a higher tax bracket.3
If you make any income-based payments, like student loans, taking an early 401(k), withdrawal may increase your taxable income for the calendar year. This may cause these income-based payments to rise until you file your next income tax return.
For example, if you take a $10,000 early 401(k) withdrawal and you are already in the 22 percent tax bracket, you may net only about $7,200 after paying a $1,000 IRS penalty plus a 22 percent tax rate on the remaining $9,000.4 Those in higher tax brackets, paying a 37 percent tax rate, could end up with as little as $5,670 from their $10,000 withdrawal after paying the penalty and income tax.
Loss of Potential Future Gains
The other way in which an early 401(k) withdrawal might cost you is the potential loss of future investment earnings. Leaving money in your 401(k), instead of withdrawing it, might help you earn more for your retirement. However, investing involves risks, including the possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Contributions to a 401(k) are limited for each tax year, depending on a person’s age. In 2021, the limit is $19,500 for those under 50. It may be harder to make up for any withdrawal by contributing more in the future. The annual catch-up limit is $26,000 in 2021 for those 50 and older.5 When you factor in the potential of investment growth, a relatively small withdrawal could wind up costing you tens of thousands of retirement dollars.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
LPL Tracking #1-05172399