Taking money out of a 401(k) plan before age 59 1/2 often results in taxes and penalties. Investors who take early 401(k) withdrawals also miss out on the investment returns they could have earned if they left the money in the account.
Here's what happens if you withdraw money from your 401(k) account early:
-- You could trigger a higher tax bill.
-- You may have to pay a penalty.
-- Your request might be denied.
-- The withdrawn funds won't earn interest.
-- The distribution might not be protected from creditors.
Read on to find out how a 401(k) withdrawal before age 59 1/2 could impact your taxes and future investment returns.
You Could Trigger a Higher Tax Bill
Money withdrawn from a traditional 401(k) is considered taxable income for the year it is taken out. "Consider how a distribution will affect your taxable income, along with how that additional income might affect any other tax matters that phase out based on income," says Steven J. Weil, president of RMS Accounting in Fort Lauderdale, Florida. For instance, if the withdrawal increases your income to the point that you are in a higher tax bracket, your tax rate could increase. The higher income could also lead to fewer deductions and credits, as some don't apply to people with income above a certain level. Child tax credits, education deductions and passive real estate loss deductions are all based on income.
However, if you are taking the withdrawal due to a financial hardship, such as a job loss, the withdrawal's impact on taxes may be different. "If income is low due to a change in your financial circumstances, it may make sense to take a withdrawal at the lower tax rate," says Joseph Guyton, principal and founder of the Guyton Group in Portsmouth, New Hampshire.
You May Have to Pay a Penalty
Many 401(k) plans allow you to withdraw money for a financial need that is considered immediate and heavy, such as high medical care expenses, costs related to a home purchase or repair, higher education expenses or funeral expenses. You'll need to meet certain criteria to be eligible to take a distribution while working for the company that provides the 401(k) plan, and you'll only be able to withdraw an amount that satisfies the need. If you withdraw funds from a 401(k) before age 59 1/2, you will likely have to pay an early withdrawal penalty. "Distributions are subject to a 10% penalty prior to 59 1/2," Guyton says. For example, taking out $10,000 would result in a 10% penalty of $1,000.
The IRS has additional rules that occasionally allow for penalty-free hardship withdrawals. Employees who are laid off, fired or quit a job between ages 55 and 59 1/2 can take money out of their 401(k) without penalty. "Another obscure IRS rule is the 72(t) rule, which allows for an individual to take at least five substantially equal periodic payments from a retirement account over five years or until the individual reaches age 59 1/2, whichever is earlier," says Daniel Milan, managing partner of Cornerstone Financial Services in Southfield, Michigan. You can also avoid the 401(k) early withdrawal penalty if you have large medical expenses, you are totally and permanently disabled or you are a member of the military reserve and take a distribution during active duty that exceeds 179 days.
Your Request May Be Denied
Some plans have restrictions on when withdrawals can be made. If you are still working, check with your employer to see if early withdrawals are allowed. "Not all plans allow employees to remove funds while still employed," says Isaiah Goodman, chief financial advocate at Becoming Financial in Minneapolis.
Many 401(k) plans allow you to access your retirement savings as a 401(k) loan. You might be able to take out a 401(k) loan of up to 50% of the current value or $50,000, whichever is less. The money is generally paid back at set times through automatic paycheck deductions. "This could be an option to cover an immediate need without depleting funds for your retirement future," Goodman says. However, if you leave your employer, the full amount of the remaining balance will usually need to be paid back by the due date of your federal tax return. If you don't pay the amount owed, it will be treated as a taxable withdrawal.
The Withdrawn Funds Won't Earn Interest
Retirement accounts are designed with the idea that you may earn a return on your investment over time. When you remove funds, the money that was invested in the account no longer has a chance to increase.
Retirement savers can defer paying income tax on the money they contribute to a 401(k). The funds can grow tax-free until you take them out. You miss out on the tax deferral benefit when you take money out of the account early.
In addition, if you withdraw 401(k) funds before retirement, you might be reducing the overall amount available to you in the future. It could take several years or longer, depending on the amount withdrawn, to rebuild the retirement fund and plan for future income needs. "This could cause a delay in the start date of retirement," Guyton says.
The Distribution Might Not Be Protected From Creditors
If you owe a significant amount in debt, taking an early withdrawal could lead to creditors claiming the amount. In some states, money in qualified plans "is protected from the claims of creditors, which can be valuable for those with substantial debt or personal liability," Weil says. In these cases, you might decide to look for other ways to access cash or pay off debt rather than taking the money out of a 401(k). "Consult a qualified tax advisor before taking any action," Weil says.
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