Understanding 401(k) Basics and Withdrawals
While your retirement savings should ideally be left untouched until retirement, it’s not uncommon for people to tap into their 401(k) savings when facing a cash crunch or needing a large sum of money. It can be tempting to pull from that reserve, but doing so will cost you. By taking from your retirement fund, you’ll miss out on future savings and earnings that would otherwise fund your retirement years. Below, we will discuss the benefits of keeping your 401(k) funded and options to rebuild your 401(k) if you made the hard choice to withdraw money early.
A 401(k) is a retirement savings and investment vehicle typically provided by your employer. Contributions are made pre-tax from your paycheck at whatever percentage you elect. Most employers, but not all, offer to match a portion of your contributions. This is a great incentive to save so make sure you take advantage of it. However, there are contribution limits to be aware of and they can change from year to year.
A 401(k) is great over the long term because of compounding interest. Compounding interest is the interest gained on a principal deposit from previous periods. For example, a 25-year-old who invests $5,000 a year with an 8% average annual return for 43 years should have approximately $1.65 million. If you started saving 10 years later and invested $5,000 per year with the same 8% average annual return, after 33 years the result is approximately $729,750. While the $5,000 contribution per year may not sound like much in the short-term, the snowball effect of compounding interest makes early investing very enticing and yields benefits up until you withdraw that money.
Understanding 401(k) Withdrawals
It’s important to understand that withdrawing money early from your 401(k) can carry heavy financial penalties, so the decision should not be made lightly. It really should be a last resort. Generally, if you take a distribution from your 401(k) before age 59 ½, you will owe both federal income tax and a 10% penalty on the amount that you withdraw, in addition to any relevant state income tax. When you start to combine those figures, it adds up quickly. There are some exceptions to the rules allowing for early withdrawals without penalty. Examples are listed below:
- Hardship Withdrawal – According to IRS rules, a hardship withdrawal lets you pull money out of the account without paying the usual 10% early withdrawal penalty charged to individuals under age 59 ½. Some examples of a hardship are medical expenses, funeral costs, avoiding foreclosure or eviction, home repairs after a natural disaster.
- CARES Act – An act initiated from the pandemic that provided more flexibility for making emergency withdrawals from a tax-deferred retirement account by eliminating the 10% early withdrawal penalty. Participants are allowed to withdraw up to $100,000 per person without being subject to a tax penalty.
- SECURE Act – The SECURE Act of 2019 allows for a withdrawal up to $5,000 without penalty to pay expenses related to the birth or adoption of a child.
- Other Exceptions – According to the IRS some other withdrawals without penalty include a down payment on a first home, qualified educational expenses and medical bills. However as with the hardship withdrawal, you will still owe the income taxes on that money, but you won't owe a penalty.
If you’ve considered all options and find yourself still needing to take money out of your 401(k), there are two primary paths for getting your money.
- Traditional Lump Sum Withdrawal – As mentioned above, you won’t be getting your full amount since your withdrawal is subject to early withdrawal penalty and/or taxes. Financial experts warn that the total tax and penalty amount could be close to 30%, meaning you’d only get $7,000 if you decided to withdrawal $10,000.
- 401(k) Loan – With a 401(k) loan, you borrow money from your retirement savings account. Unlike a 401(k) withdrawal, you don't have to pay taxes and penalties when you take a 401(k) loan. Remember, you'll have to pay that borrowed money back, plus interest, within 5 years of taking your loan, in most cases. The benefits are obvious in that you avoid the taxes and penalties, however if you decide to leave your job with the current open 401(k) loan, you may have to pay that loan back in a shorter timeframe. Loans are not always offered and eligibility is up to the employer’s plan, so check first to see if this is even an option for consideration.
Replenishing Your Retirement
Whether you pulled money out early or started saving late, there are steps you can take to increase your retirement savings. If your employer offers a matching program, make sure to meet their match. If your employer offers to match 50% of your contributions up to 5% of your salary, take the money they’re giving you and contribute at least 5%. If you’re over 50, use catchup contributions. If over that age and you haven't been able to save as much as you would have liked, catch-up contributions can help boost your retirement savings. Lastly, always increase your contributions over time. Don’t settle for the same rate year over year, make it a goal to increase your contributions 1% or 2% every year.
It’s best to explore and exhaust all other options before tapping into your retirement savings. Of course it’s difficult to predict all of life’s obstacles and unforeseen circumstances which is why it’s important to be aware and informed of your options should you look at utilizing your 401(k). Before it gets to that point, begin taking control of your finances now, living within your means, saving each month and staying on top of your debt.
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