Like many people, John Cline assumed he would have a nice nest egg saved up by the time he was ready to retire. But life doesn’t always go as planned. At age 45, Cline found himself faced with a difficult financial situation that led him to make the tough decision to cash out his 401(k) early.
How He Got There
Cline had diligently contributed to his 401(k) since starting his career in his early 20s. By age 45, he had a balance of around $180,000 saved up. He was on track to retire comfortably at 65. Then Cline went through a divorce, which meant he needed cash quickly to buy out his ex-spouse’s share of their house to avoid selling it. On top of that, Cline’s elderly mother got sick and required expensive medical treatments not fully covered by her insurance.
Between the divorce lawyer fees, house buyout and helping his mom with medical bills, Cline was burning through his savings fast. His emergency fund was gone within a few months. Cline looked into taking out a home equity loan or personal loans from the bank, but kept getting denied because of his high debt-to-income ratio from the divorce settlement. He felt like he had run out of options.
The Heartbreaking Decision
After agonizing over the decision, Cline chose to take a hardship withdrawal from his 401(k) to cover the expenses. His plan allowed for hardship withdrawals for unreimbursed medical bills and payments to buy a primary residence. Cline withdrew $80,000 from his 401(k), which was a big chunk of his entire balance.
Not only did this drastically reduce his retirement savings, but Cline also had to pay income taxes and a 10% early withdrawal penalty, since he was under age 59 1⁄2. After taxes and penalties, the $80,000 withdrawal left Cline with only about $56,000 of usable cash. It was painful to see over $20,000 disappear like that.
What He Learned
That experience taught Cline firsthand just how financially devastating cashing out a 401(k) early can be. Here are a few key lessons he learned:
- The taxes and penalties almost negate the purpose of taking the money in the first place. You lose out on a significant portion of the withdrawal.
- It permanently reduces your retirement savings. That money is gone from your account for good.
- It derails your retirement planning. You have to basically start over from scratch rebuilding that nest egg.
- It should only be a total last resort. Cline realized in hindsight that he should have cut expenses more dramatically before dipping into retirement savings.
Although tapping his 401(k) early was a huge setback, Cline has managed to rebuild his retirement savings significantly over the past few years,. Here are some of the steps he took:
- He immediately resumed 401(k) contributions and increased his contribution percentage to the maximum allowed by his plan. Cline also signed up for auto-increase so his contributions go up by 1% each year.
- Cline started a side business doing freelance consulting in his field, which provides an extra $400 per month of income that he invests in an IRA.
- Cline made budget cuts like eating out less, cutting out streamers and other subscriptions and reducing discretionary spending. “Not going out to dinner was the biggest sacrifice,” he said, “but hey, I’ve gotten pretty good at making a mean vegetarian chili.” He invested the savings.
- He also opened a health savings account (HSA) and maxes out contributions to it each year to help save for medical expenses in retirement.
- Cline shifted his retirement investing strategy to focus more on growth while he still has time to ride out market swings.
With these steps, Cline has managed to save well over the amount he withdrew. Of course, he wishes he hadn’t cashed out his 401(k) in the first place. But by taking deliberate steps to increase savings, he’s back on track for retirement, and in some ways saving more than ever.
Advice for Rebuilding Retirement Savings
According to financial advisor Jeff Rose of Good Financial Cents, cashing out a 401(k) early can feel like a major setback; but, with some strategic moves, it is possible to rebuild your savings and get retirement planning back on track.
Some of his suggestions included immediately resuming 401(k) contributions after any restrictions and increasing contributions to the maximum amount allowed. Aiming to max out 401(k) contributions each year can make a significant difference over time. Even contributing below the max but more than you were before can have an impact.
In addition to ramping up 401(k) savings, Rose advised exploring ways to generate supplemental income that can be invested for retirement, such as starting a side business. If you can create an extra $500 per month from a side gig and invest it for retirement, you could potentially add over $100,000 to your nest egg in just 10 years, assuming average market returns.
Other moves Rose suggested are opening an HSA if you have a high-deductible health plan, making cuts to discretionary spending so you can invest the savings, and shifting to a more growth-oriented investment strategy while you still have time to ride out market fluctuations.
By taking steps like these, Rose believes it’s possible to rebuild retirement savings even after major setbacks. With diligent planning and disciplined saving habits, you can get back on track and reach your long-term retirement goals.
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