If you’re eyeing a new house or struggling to put your child through college, you might be considering dipping into your retirement funds. But before rushing to use your hard-earned 401(k) money to pay for these expenses, consider the tax penalties for 401(k) withdrawals — they can largely impact your finances.
Tax Penalties for 401k Withdrawals
You must follow the guidelines on tax penalties for early 401(k) withdrawals before you start taking money out of your 401(k).
First of all, if you plan on drawing from your 401(k) and you’re under 59 ½ years old, you will be facing the 10 percent tax penalty. That tax penalty is not withheld automatically from the distribution, so you will have to account for this when you file your tax return. The good news is that you have some months before it’s due, which allows you to save up the amount you potentially owe.
Also, you will typically have 20 percent withheld from the distribution. According to online trading brokerage firm Fidelity, this percentage of your balance is sent to the IRS to cover possible taxes you’ll have to pay on the withdrawal. So, if you’re withdrawing $10,000, you will prepay $2,000 and net $8,000.
Combining the 10 percent tax penalty with the 20 percent holding means that if you withdraw $10,000, you’ll have to pay $3,000. As a result, your total withdrawal is only $7,000.
A 401k Early Withdrawal Could Cost You Earned Interest
A 401(k) early withdrawal will not only result in tax penalties, but you will lose out on a large sum of money you could’ve accumulated in your 401(k) had you let the money grow over time. Take the following example:
- You are 40 years old.
- Your funds are earning an average of 7 percent annually.
- You have a balance of $300,000.
At a 7 percent annual rate of return and using the rule of 72, the balance will double in value about every 10 years, assuming you’re not making additional contributions. So at age 60 years old, your 401(k) could be worth $1,200,000.
But if you withdraw $100,000 early from your 401(k), your balance goes from $1,200,000 down to $800,000 at age 60. With a 7 percent annual rate of return, you will have to wait another six years to reach $1,200,000.
3 Purchases That Aren’t Worth the Tax Penalties on 401k
If the 401(k) early withdrawal fees and tax penalties, as well as the interest you will lose out on, haven’t convinced you to think twice before withdrawing money from your 401(k) early, then take a look at what could happen if you use your 401(k) funds to buy a house, pay for college or get out of debt before you turn 59 ½:
1. Buying a House
People often consider using 401(k) funds for down payments for their first homes. Let’s say:
- You are 50 years old.
- You need to withdraw $50,000 to pay for a $30,000 down payment.
- You have a salary in 2015 of $90,000.
- You will be filing a joint tax return in 2016.
- You are in the 25 percent marginal tax bracket.
These will be your costs for an early 401(k) withdrawal of $50,000:
|Penalties & Fees||Cost|
|10% Tax Penalty||$5,000|
|20% Mandatory Withholding||$10,000|
|25% Tax Bracket (already 20%, 5% more)||$2,500|
|Potential State Income Tax of 5%||$2,500|
|You will have paid:||$20,000|
|You will have netted:||$30,000|
Consider also that if your funds are averaging a 7 percent return and you plan to retire at age 60, 10 years from the withdrawal date your $50,000 that you used would have been worth at least $98,000. So, not only did you have to pay $20,000 to the IRS, but you missed out on earning $48,000 over time.
2. Paying for College
Perhaps you’re considering your 401(k) funds to pay for your child’s college tuition and fees. Although paying for school seems like a valid reason to withdraw from your 401(k) early, you’ll still get hit with a tax penalty. The only way to avoid the 10 percent early withdrawal tax penalty is to use an IRA distribution to pay for college.
But since we’re talking about tax penalties for 401(k) withdrawals, consider the following example:
- You are 50 years old.
- Your salary is $90,000.
- Your marginal tax bracket is 25 percent.
- You need to withdraw $50,000, but take out $12,500 annually instead of all at once.
- Your retirement age is 60 years old.
The advantage — small as it might be — of taking out $12,500 each year for four years is that in Year 1, you have $37,500 still working for you in your 401(k). Here’s what will happen when you withdraw $50,000 from your 401(k), assuming that your initial balance was $50,000:
|Number of Years in College||Amount in 401(k) After Withdrawing $12,500||Earnings Based on 7% Annual Rate of Return||Total Amount in 401(k)|
After your child has graduated college, you can start to grow your 401(k) balance again. But in six years, your balance would only total $9,239.
And don’t forget: You would still have to somehow pay the 401(k) tax penalty of $20,000.
Keep reading: How to Become a Millionaire Using Just Your 401k
3. Paying off Debt
These days, it’s not unusual for some folks to have $20,000 in credit card debt. But does it make financial sense to use 401(k) money to get out of that debt? Let’s consider the two cost of funds: the cost to carry the debt vs. the cost of withdrawing 401(k) funds to get out of debt.
If you carry $20,000 and pay an 18 percent interest rate with minimum payments at 4 percent of the balance, you will pay $800 per month for more than 15 years before you’re able to pay off the $20,000. Assuming you don’t add any more to the credit card balance, you will pay a total interest of nearly $11,900.
By taking out $20,000 from your 401(k) — you will incur the 10 percent tax penalty and marginal tax of 25 percent — it will cost you $7,000. And remember, if you don’t have the $7,000 to pay the taxes, you will have to get more from your 401(k) to net $20,000. So, you would actually need to withdraw $30,769 and pay the taxes of $10,769 to net $20,000.
But there’s more: You no longer have $30,769 earning interest in your 401(k). If you’re 40 years old and have 20 years to go, the $30,769 you withdrew would have grown to $124,267 with a 7 percent annual return had you left it in your 401(k).
While it seems like a good decision to pay only $7,000 instead of nearly $12,000 in interest in order to pay off your credit card debt using your 401(k) money, why not increase your credit card payments to accelerate the payoff?
Try paying 6 percent of the balance each month instead. Now, the $20,000 with 18 percent interest is paid off in 9 years rather than 15, and you pay only $6,623.18 in interest — this is clearly a better alternative to an early 401(k) withdrawal that will cost you $7,000 plus lost interest.