Are you contributing to your employer’s 401(k) plan? Taking advantage of this retirement savings vehicle is a no-brainer when it comes to having an easy way to save money for retirement each month. According to the Bureau of Labor Statistics, the average 401(k) match nets out to about 4 percent,1 which may initially not sound like much, but with compounding interest, this amount can quickly add up as you contribute funds throughout your working years.
Census Bureau research has found that about 80 percent of Americans are eligible to contribute to a 401(k) plan, however, only about 40 percent of employees actually do.2 Not taking advantage of a 401(k) match is akin to leaving "free money" on the table. This low participation could be due to a lack of employee education and awareness of 401(k) plan benefits. For those unsure about the rules and stipulations surrounding 401(k) plans, consider hiring a financial advisor who can walk you through each detail so you’re well-versed in the vehicle’s requirements.
According to E-Trade Financial, “nearly 60 percent of investors ages 18 to 34 say they already have taken money from their retirement account.”3 This number is nearly double what it was in 2015 and is due, in part, to millennials carrying some of most student loan debt when compared to older generations.3 In fact, many millennials have wages that are lower than what their parents were making when they were in their 20s and 30s. If you have a decent amount of money saved up, it can be tempting to withdraw your 401(k) funds sooner than originally planned. However, there are a variety of reasons why doing so will not benefit you in the long-run.
Overview of 401(k) Plans
Two benefits of a 401(k) plan include tax-deductible and tax-deferred contributions. This means that you’ll not only save on taxes but that you also won’t have to pay many taxes until you withdraw your money. However, you can only take advantage of these benefits if you follow specific 401(k) plan rules.
In most cases, any 401(k) withdrawal you make is going to be taxable as ordinary income, With most 401(k) plans, you’re not expected to withdraw these funds until you are at least 59½. If you make an early withdrawal, you’ll incur a 10 percent early distribution penalty tax on the amount you take out. And that’s only one of the many disadvantages of withdrawing from your 401(k) plan early.
Disadvantages of Withdrawing 401(k) Funds Early
Withdrawing your 401(k) funds before you’re 59½ can practically eliminate the main benefits of a 401(k) plan: tax deductions. This is caused by a number of penalties attached to early withdrawals. As mentioned previously, any withdrawal amount is considered to be taxable ordinary income, which means you’ll be losing a significant amount of your savings simply by the timing of your withdrawal.
In some cases, you may be in a higher tax bracket when you withdrawal the money than when you’re in retirement, which can greatly increase the amount of taxes you’ll have to pay once you do withdraw. Additionally, by taking your money out early, you’re preventing it from growing and multiplying, which is one of the main reasons to contribute to a 401(k) plan. While the reward may initially seem worth it, by the time you get to retirement, these funds will most likely be missed. Ultimately, the longer your money sits in a 401(k), the more it will compound.
Early Withdrawal Exceptions
While there are exceptions to early withdrawal, it’s important to note that your withdrawal will still be counted as taxable ordinary income. However, if you meet one or more of the below exceptions, you will not have a 10 percent penalty to pay.
As always, make sure to read your own individual plan’s requirements, as not every 401(k) plan follows the same rules.
You may be able to withdraw from your 401(k) early with minimal consequences if:
- You have a disability.
- You were fired from your job when you were 55 or older.
- You have significant medical expenses.
- You have a qualified domestic relations order.
Or sign up to receive monthly insights from our Early Retirement Newsletter!