If you find yourself deeply in debt, struggling to make payments, or tired of enduring the tedious nature of the debt repayment process, an early 401k withdrawal appears to be an incredibly appealing option.
You may think that dipping into your 401k early is the solution to your problems and you’ll rationalize how this move will fast track your financial success.
First off, you’re not alone. The average American is drowning in a sea of debt. Credit cards, student loans, vehicles, personal loans, hell… you can even finance the phone you’re reading this on. Most likely, you did.
The monthly payments are crippling your financial progress. You’re stuck living pay check to pay check and it’s causing stress, anxiety, and potentially arguments with your spouse. For these reasons it’s easy to see why the thought of cashing in your 401k early and pole vaulting out of this financial hole is wildly appealing.
An early 401k withdrawal feels like a warm blanket on a cold day. Your financial problems will end. The birds will come out, the sun will shine, and your life will rapidly improve.
Sounds pretty awesome, right? Wellll… before you take an early 401k withdrawal, you should consider both the short-term and long-term financial issues you’ll be facing.
What’s Is An Early 401k Withdrawal?
A quick and dirty explanation of an early 401k withdrawal is pretty simple… you take money out of your 401k before age 59½. It can be a bit more complicated than that though.
Your employer will dictate exactly how you complete an early 401k withdrawal. Some may not even permit it, but the first place to start would be with your HR (human resources) department. Find out what you’re allowed to do.
After talking with HR, contact your retirement service provider and discuss your options and process for getting your money.
Proceed with caution from here on out… If you withdraw your 401k prior to 59½, you’re going to pay federal and state taxes. You’ll also pay a nice 10% early withdrawal penalty.
There are some extenuating circumstances that will allow you to complete an early withdrawal from your 401k without the 10% penalty. If you qualify for a penalty free withdrawal, you’re dealing with other issues besides debt.
Here are some of the ways you can take an early withdrawal from your 401k.
- You die and your 401k gets paid out to your beneficiary (obviously, this sucks)
- You become totally disabled and not able to work (this also blows)
- Some hardship situations (yep… blows again)
- If you leave your employer and are at least 55 (might not be too bad)
- Medical expenses that are greater than 7.5% of your adjusted gross income (yep, still not good)
- Court order to provide financial support for children, dependents, or a divorced spouse
- 72t Early Distribution (probably the best of these awful options, but still not perfect)
Nowhere on that list is “I want to quickly pay off debt”… and that’s actually a good thing. Consider the penalties and taxes a safe guard for you, because they prevent you from making a poor financial decision.
Your immediate desire isn’t as important as needing money when you’re 80. Keep that in mind.
What Would An Early Withdrawal Look Like?
Let’s assume you’re $40,000 in debt, and you have $50,000 in your 401k. Boom, no brainer right?!
Debt freedom is… literally… right there! All you have to do is cash out your 401k and bring that $50,000 home in a suitcase, roll around in it, pay off your debt, and then buy a car with the remaining $10,000.
Psshhh, debt freedom isn’t hard at all. (clapping)
Ehhhh, hold up. You won’t be bringing home $50,000… you won’t even bring home $40,000. Uncle Sam is waiting and he has a big tip jar that needs filling before you’re paid.
First off, a 401k withdrawal is considered earned income by our friends over at the IRS. Dropping a large sum of money into your “income” bucket can bump you into a higher tax bracket as well.
Your employer will be required to withhold federal and state taxes right away and they will send you a 1099-R around tax time.
Remember that the taxes withheld are only an estimate and you’ll be hit with your true tax bill in the spring.
- A 1099-R is a tax form that deals with income from other sources apart from your salary. Your 401k withdrawal would fit that criteria and you’d then be required to file this form when you complete your income tax return. If they happen to not deduct the correct amount of federal taxes from your withdrawal, you’ll end up with a hefty tax bill the following spring…
Moral of that story is TALK TO A CPA FIRST!
Let’s assume you’re going to pay a total of 24% in federal taxes, 6% in state taxes, and a 10% penalty.
- $50,000 x 24% = $12,000
- $50,000 x 6% = $3,000
- $50,000 x 10% = $5,000
- Total Payout: $30,000 (womp womp)
And, poof… just like that, you’ve cashed out your 401k and you’re still in $10,000 in debt.
So… When Would an Early 401k Withdrawal Be a Good Idea?
I struggle with this one… mainly because I don’t think it’s ever a good idea to cash out your 401k to pay off debt.
However, there could be a case for an early 401k withdrawal if your livelihood, or the livelihood of your family is going to be placed under extreme, life-altering duress.
Let’s assume that your debt is going to cause you to become:
- Harm your family (physically, mentally or emotionally)
- Impede your ability to provide basic life necessities for you or your family
If the livelihood of my family was on the line, I would use my 401k to prevent life altering hardships that I couldn’t prevent despite my extraordinary efforts.
An early 401k withdrawal should be considered a last ditch effort. You should exhaust all other options first. Take on a second job, sell everything you can possibly sell, and take on an extremely frugal lifestyle. Hell, donate plasma!
If after all your possible effort, your family’s livelihood and safety are at risk… the 401k withdrawal becomes a viable, yet painful option.
It’s not a quick fix and it’s not to be viewed as the easy way out. You’re making a gigantic financial decision that will set you back years, if not decades.
Wait…What About Preventing Bankruptcy
Preventing bankruptcy by dipping into your 401k is a debatable topic. You’ve accrued the debt. Maybe it’s medical bills (less than 7.5% of your AGI) or maybe the debt is a result of your poor financial decisions.
How you handle the topic of bankruptcy is personal. We all have our own moral compass, and how you settle your debt is your call. You should know that federal law protects your 401k from creditors. This is assuming you haven’t withdrawn the money.
Again, talk with a financial professional about your options.
If you decide to use your 401k to prevent bankruptcy, the same penalties, taxes, and potentially negative long-term consequences apply.
What Are Some Other Reason Not To Withdrawal Your 401k
Believe it or not, there are more reasons besides fees and taxes that should prevent you from taking an early 401k withdrawal. If the fees and taxes don’t sway you, perhaps these other reason might…
Resetting Your Compound Interest
An early 401k withdrawal will certainly fix your debt problem now. Or, it will at least help reduce your debt. What about the long term impact?
Compounding interest is real, and it’s a powerful wealth building tool. Here is a great example of compounding interest.
Let’s say it took you 10 years to save that $50,000 and at the age of 30, you invest it in the S&P 500. If you didn’t contribute another penny from that day forward, you’d have $663,383.92 at the age of 59. You’ve only contributed $50,000 and have amassed $613,383.92 in growth!
This is assuming a 9% return on your investment (S&P 500 Average return)
Now let’s say you decide to cash out your 401k now, and then start investing again at the age of 30. You’ll still invest $5,000 a year until age 59.
You’ll have $620,666.85 after 29 years of saving! Not bad, right? The difference is the fact you’ve contributed $145,000 of your own money!
Let’s make it worse… suppose that you have the $50,000 and continue to invest $5,000 a year for 29 years. You’d have $1,229,275.96. Wha, wha, what?!
Cashing in that $50,000 now to pay off debt will actually cost you over $600,000… (mind blown)
Compounding interest is an incredibly powerful tool. The problem with compounding interest is that we often lack the ability to look ahead 20 or 30 years to understand the importance of it…
If you’d like to play around with a great compounding interest calculator, check out the one at Investor.gov. It’s the best one I’ve found.
Not Changing Your Bad Money Habits
It took us over 4 years to pay off the $109,000 in consumer debt we owed. It was tedious, it was painful, and it changed our view of money forever.
There is something about going through the pain of repaying your debt that changes you. Your purchases mean more to you, and your ability to control your “wants” drastically improves.
By utilizing a 401k early withdrawal, you’re bypassing the necessary life changes and emotional pain that accompanies debt repayment. This would be similar to a crash diet. Sure, you’ll lose weight by not eating a carb for a month.
Will you be able to maintain that lifestyle? Statistically, no. You won’t. I’ve done it, and the weight comes back.
Cashing out your 401k early isn’t really any different. You haven’t made any lifestyle changes to solidify your ability to remain debt free for a sustained period of time.
The risk of reacquiring debt is huge. It makes my eye twitch to think of someone losing 401k and ending up back in the same position a few years or months down the road…
That would be a disaster on many levels.
You’re not guaranteed to remain debt free even if you take the long road, but at least you’ll still have that 401k and compounding interest building wealth for you.
You’re Going To Get Old… Hopefully
One of the most difficult things to do is look 10, 20, or even 30 years down the road. But I’ve got news for you…hopefully you’re going to get old. And when you do get old, you’re going to need money.
A 401k withdrawal might solve your problems now, but it could set you up for some devastating problem years later.
Before you take any action, consider what your 65 year old self would think. Will 5 years of tedious debt repayment be a big deal when you’re 65? Probably not.
Will drastically reducing your retirement savings matter at 65? Yea… that’ll be a huge problem! This decision could be the difference between retiring at 60, 65, 70, or never at all.
Hell, this decision might cause you to work two jobs late into life trying to save up a comfortable nest egg.
Don’t let your desire for a quick fix add years on to your retirement planning… Your 65 year old self will thank you, tremendously.
The desire to fast track your debt freedom often clouds long-term thinking. A 401k withdrawal feels like a solution when you’re stuck living pay check to pay check.
When you’re struggling each week, the thought of retirement is comical at best.
An early 401k withdrawal is rarely the correct long-term solution, even when you consider that debt freedom is a massive part of the financial freedom puzzle.
Before you pull the trigger and cash out your retirement nest egg, consider the long-term consequences, and make the right choice for you entire life. Not just what feels right today.
I think you’ll find that an early 401k withdrawal is rarely the correct answer, it’s just the easy fix to a very difficult problem.
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