Taking money out of your 401(k) account before retirement is an act of fiscal insanity, advisors say. Let me tell you why.
First, let's back up and give a little context. A 401(k) is an employer-sponsored plan that allows you to defer taxes on money you put in your "nest egg" until you're ready to retire, or at age 59 and a half.
After retirement most people are in a lower tax bracket than in their working years. So with a 401(k) you get to watch your money grow for years before having to pay taxes. Even with that tax advantage, under 50 percent of Americans contribute to any type of retirement plan, and when they do, they put in less than seven percent of their annual salary. So if your 401(k) is underfunded in the first place, taking money out makes matters worse.
Let's do some simple math and show you how it works:
I'm 43-years-old and I'd like to retire at 65. If I withdraw $20,000 from my 401(k), after taxes and penalties, that $20,000 becomes $13,000, net. If I'd left that money in the 401(k) on the other hand, and made just five percent a year, that $20,000 thousand would be $75,000 when I'm 65.
It's a huge difference. It's a no-brainer, I'm taking the $75,000 .
But there may be a time when it's not necessarily a bad idea to withdraw money from your 401(k) before retirement. The IRS allows investors to take hardship distribution if there is an immediate financial need, such as medical or funeral expenses or avoiding bankruptcy.
You might also consider withdrawing from your 401(k) if your credit score is low and you have problems getting credit at affordable rates. Dipping into your 401(k) in order to buy a home could be considered if the additional funds are needed for a down payment. If you plan to stay put, over the length of the loan, the value of your home has potential to appreciate offsetting some the retirement money you might lose.
Bottom line: Withdrawing from a 401(k) is costly any way you look at it and only makes sense when money is desperately needed and there is absolutely no other way to get it.
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