Generally speaking, 401(k) retirement accounts are designed to remain untouched until you have reached retirement age. You are not allowed to withdraw funds from your 401(k) account prior to the age of 59 ½ without being hit with significant penalties and charges, although certain exceptions may apply.
There are three main consequences to pulling your money out of your 401(k) account early:
- Withheld funds
Usually the Internal Revenue Service (IRS) will require 20 percent of your early withdrawal be withheld in order to pay for your tax liabilities. This means if you withdraw $20,000 from your 401(k) account early, you will only receive approximately $16,000 back. However, you should also realize there is a chance to receive some of the withheld funds back in the form of a tax refund, depending upon how much you owe at the time of filing your taxes.
- IRS penalties
Pulling out money from a 401(k) account prior to reaching 59 ½ years of age generally triggers an automatic 10% penalty levied by the IRS. This penalty will be levied upon your next tax return filing. This means if you withdraw $15,000, you will have to pay the IRS a penalty charge of $1,500.
- Diminished retirement capital
Another negative many people forget to think about when withdrawing early from their 401(k) account is that they are diminishing the amount of future funds they will have available to them upon retirement. Basically, when you are pulling money out of the 401(k) account you are selling equities and other investment vehicles your account manager has bought using your deposited capital.
This can be an issue if you take into consideration 401(k) accounts are mostly invested in the stock market which has an upward bias. Essentially, the stock market in the aggregate will tend to move upward over long periods of time. Therefore, generally speaking, the longer you are in the market, the more capital gains you are likely to earn.
So, if you take all the money out of your 401(k) account, you will be missing out on the future returns you would normally have earned if you had kept the funds invested. This can be particularly detrimental if you withdraw after a significant move downward in the market. In the end, this means you will have less funds to use during your retirement years.
Have a plan
After careful consideration of the potential penalties you will incur from withdrawing early, you may still decide to move forward with pulling funds from your 401(k). In this case, you should make sure to have a plan on what you want to do with these funds and integrate this change into your overall retirement planning. You may also want to investigate potential exemptions to the IRS penalties. A financial professional may be able to help you navigate the different aspects of withdrawing early.