Taking funds out of a 401(k) before age 59 1/2 will often trigger taxes and fees. The costs related to an early withdrawal can be both short-term and long-term. However, there are some ways to minimize the costs of an early 401(k) withdrawal.
Before you take an early 401(k) withdrawal, consider:
— The 10% early withdrawal penalty.
— The 20% tax withholding for a 401(k) early withdrawal.
— Income tax due on an early withdrawal.
— Missed investment growth.
— Ways to minimize the related costs.
The 10% Early Withdrawal Penalty
There is typically a 10% early withdrawal penalty if you take a 401(k) distribution before age 59 1/2. A 40-year-old who takes a $10,000 withdrawal would owe $1,000 if the 10% penalty is applied.
However, there are some exceptions to this rule. If you meet certain criteria, you won’t have to pay a penalty for an early withdrawal. For example, if you leave your job in the year you turn 55 or later, there won’t be a penalty on withdrawals from the 401(k) associated with that job. The penalty also doesn’t apply if you have a qualifying disability, set up substantially equal periodic payments from the account, or use the funds for several specific purposes, such as significant medical expenses or to recover from a qualifying natural disaster. If you do not qualify for an exception and have not yet turned 59 1/2 years old, you can expect to pay a 10% penalty on an early 401(k) distribution.
[See: 9 Ways to Avoid the 401(k) Early Withdrawal Penalty and Other Fees]
20% Tax Withholding for a 401(k) Early Withdrawal
You can expect 20% of an early 401(k) withdrawal to be withheld for taxes. In the case of a 40-year-old in the 24% tax bracket who withdraws $10,000, some funds would be set aside for the IRS. “Federal taxes would be withheld at 20%, so the participant would only net $8,000,” says Andrew Cooper, a financial planner and the president of Cooper Eagle in West Chester, Pennsylvania. “Once taxes are filed after the end of the tax year, the 10% penalty would be owed on the $10,000.”
Income Tax Due on an Early 401(k) Distribution
When you withdraw funds from a 401(k), they are taxed as income. For a 40-year-old who withdraws $10,000, 20% would be initially withheld. Since the individual is in the 24% tax bracket, at tax time there would be an additional amount due. “Once taxes are filed at the end of the tax year, the balance of the 4% would be paid for federal taxes,” Cooper says.
Based on the 10% penalty, the 20% tax withheld and the additional 4% tax applied, the 40-year-old withdrawing $10,000 would ultimately only receive $6,600 and owe $3,400 in taxes and penalties. The exact amount owed can vary depending on your tax bracket, circumstances and location. “In some cases, it can be even less,” says Ron Tallou, founder and owner of Tallou Financial Services in Troy, Michigan. “Depending on your state, there will be state income tax that you might pay.”
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
Missed Investment Growth
Those who take a 401(k) early withdrawal miss out on the investment growth the funds could have earned in the account. “If you decide to take out a sizeable amount today, that is less money in the plan for you that is being invested and earning interest,” Tallou says. “There can be a significantly lower balance that is compounding, and it puts you at risk of running out of money sooner.”
You can use a retirement calculator to understand how the reduced 401(k) balance will impact you over time. For a $10,000 withdrawal that reduces a 401(k) balance from $50,000 to $40,000, you might input both figures to see how the earnings will be compounded over time. For example, a $50,000 401(k) balance will grow to $233,048 in 20 years if it earns an 8% annual return. If the balance is reduced to $40,000 and the other factors remain the same, the balance would be approximately $186,438 in 20 years.
How to Minimize the Cost of an Early 401(k) Withdrawal
Consider accessing other savings accounts instead of a 401(k) if you are not yet 59 1/2 years old. If it’s possible to delay the withdrawal until you reach the eligibility age, you might be able to avoid penalties.
You could also check on a 401(k) loan option. Your plan might permit you to borrow funds from your 401(k) and set up a repayment schedule over the course of several years. Under this arrangement, you could have an amount taken from your paycheck every month for the next three to five years to reimburse the account. “By loaning the money to yourself, it would allow you to avoid the 10% penalty and the taxes because a loan isn’t considered a distribution,” Tallou says. “You intend on putting it back in full.”
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How Much a 401(k) Early Withdrawal Costs originally appeared on usnews.com
