The government grants special tax privileges to 401(k)s and similar accounts to incentivize saving for retirement. But you forfeit those perks if you treat your retirement fund like a piggy bank and raid it while you’re still young and working.
Even so, an AARP study shows that more than four in 10 people (41%) drain those accounts when they leave or lose a job. Many consider it a windfall because they don’t know what a terrible idea cashing out can be for most people in most cases.
James Allen, certified public accountant and founder of Billpin.com, used a few clever barnyard analogies to illustrate the point. “Draining your 401(k) when you leave a job is akin to eating your seed corn,” he said. “Sure, it might satiate your immediate hunger, but it leaves you with nothing to plant for next year’s harvest. The short-term relief of cash in hand is overshadowed by the long-term impact on your retirement sustainability. Every dollar withdrawn early is a potential workhorse that could have been earning its keep in your retirement stable.”
Here’s what you need to know before making any rash decisions, along with some alternatives to liquidating your all-important retirement fund.
You’ll Take a Big Financial Hit Now…
The IRS has strict rules on when you’re allowed to start withdrawing from tax-advantaged accounts — and severe penalties for doing so early.
“In the short term, taking early withdrawals from a 401(k) can lead to immediate tax implications and penalties,” said IRS Extension Online founder Alec Kellzi, a CPA who served more than 30 Fortune 500 companies as clients. “If funds are withdrawn before the age of 59½, they may also be subject to both income taxes and an additional early withdrawal penalty of 10%. This can significantly depreciate the value of the withdrawal and hinder the progress of retirement savings.”
Joe Wilson, a registered financial advisor and founder of Ten Point Financial, gave an example of just how much you’ll lose to taxes and penalties. “Depending on your tax bracket, a $10,000 early withdrawal might only net you less than $7,000,” he said.
…And a Bigger One Later
Cashing out all but guarantees the loss of 30% of what you had in the fund, but you stand to lose much, much more in compounded gains never realized in the future.
“By removing funds from a retirement account, they potentially miss out on the opportunity for their investment to grow tax-deferred over time, resulting in a diminished retirement nest egg and potentially affecting their financial security in later years,” said Kellzi.
Here, too, Wilson used hard numbers to clarify the point. “The true power of compound interest is realized years down the road,” he said. “If a 40-year-old pulls out $10,000 from their 401(k), that money could have turned into $108,000 by the time they are 65 years old, assuming a 10% rate of return.”
If necessity is driving the decision to cash out your fund, you can tap your retirement savings without liquidating them.
“If someone has the means to pay back what they would like to take out of their 401(k), they may consider taking out a loan against the 401(k) instead,” said Thomas Maluck, an NFEC-certified financial education instructor and international keynote speaker. “It will have to be paid back within five years, and there will be interest added on top of that, but you are ultimately paying it all back to yourself. Keeping the retirement account alive is more valuable than completely draining it.”
If borrowing from your 401(k) isn’t right for you, or if your plan doesn’t allow it, weigh your options and treat cashing out as an absolute last resort.
“Exploring alternatives is crucial if you find yourself in a situation where an early withdrawal is necessary,” said Terry Turner of Annuity.org, member of the Association for Financial Counseling & Planning Education. “Building an emergency fund, seeking assistance from social programs or community resources, considering low-interest loans, negotiating with creditors, or exploring additional sources of income such as part-time work or side hustles can give you extra cash flow without sacrificing retirement savings. Evaluating the necessity of early withdrawals and seeking guidance from a financial advisor is critical. They can offer personalized advice, assess potential risks and benefits, and identify the best action to balance immediate financial needs with long-term retirement goals.”
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