I’ve heard way too many friends and family members discuss their 401(k) as if it were an additional savings account.
“I’m not too worried about my credit card debt – there’s always my 401k!”
“I really want to buy a new car…look at how much is just sitting in my retirement account!”
“Oh you have debt? Just pay it off with all that extra money!”
I even dated a guy who considered cashing out his $3,000 401k to cover a $2,000 credit card bill. We broke up before I saw how that played out.
Let’s get something perfectly clear: your 401k is not a savings account. It is not “extra” money. It is a retirement account. You’re investing in your long-term financial stability, not your short-term ability to pay off a big bill (or make a purchase you clearly can’t afford).
While there are some scenarios that allow you to cash out the investments, they mostly require a change of employer and a hefty tax on the money withdrawn
If you choose to withdraw from the account (and you’re under 59 ½), you can expect to lose almost a quarter (or more) in fines and taxes. Another option many see as a short-term solution is to take a loan from their retirement account (to make a down payment on a house, for example). In this scenario, you’re still paying back the amount – with interest – using post-tax dollars!
Either way, please take my word for it. LEAVE YOUR RETIREMENT ACCOUNTS ALONE!
3 reasons to avoid an early 401k withdrawal at all costs
In case you won’t just take my word for it, here are three reasons to never (ever) withdraw early from your 401k.
1. There are usually options besides your retirement account
The idea of taking money out of this account has become so popular because many consider it a “fast and easy” solution. Unfortunately, the cons far outweigh the (minor and temporary) benefits. The worst way to screw over your future self is to make such a drastic choice before looking into all other options.
“Don’t touch your 401k until you have at least considered alternatives such as a home equity line of credit or borrowing from a family member…Feeling pressure because of harassing phone calls from creditors? Send them a certified letter requesting they stop calling. Too many medical bills? Try to work out an arrangement to pay them over time before you tap into your retirement account. Even if your creditors refuse to negotiate, if you continue to make at least a partial payment each month, you won’t be in default.”
Taking a loan against your house or borrowing from family isn’t an ideal solution, but it’s still not borrowing against your future (like a 401k loan or withdrawal would be). There are just too many options available for this to be your first choice.
2. The taxes and penalties on a 401k withdrawal are insane
So, let’s say you’re 30 years old and want to withdraw $2,000 out of your $3,000 401k fund to pay off a credit card bill. Well, because you’re 30 and not 59 ½, you can expect to lose $200 right off the top as a 10% “early-withdrawal penalty”.
Then, assuming you’re in the 15% tax bracket (which most 20-something and 30-somethings currently are), you can expect to lose another $300 on top of that. And that’s not even counting state income tax!
In this scenario, you would actually have to withdraw almost $2,700 from the account just to pay off a $2,000 debt. Is that extra $700 worth the convenience?
What you could do is take out a loan instead of a withdrawal, but where’s the benefit to that?
You typically have about 5 years to repay the loan (if you stay with the same employer) before it goes into default and you’re hit with the same penalty and income tax as the above example.
Even without the penalty and tax, most plans charge an origination fee of $75 regardless of loan size. This goes to the loan administrator – not back into your retirement account. Even if your plan doesn’t charge an origination fee and you don’t let the loan go into default, you’re still losing money.
You’ll be repaying your future self (with interest) using after-tax dollars.
Considering the greatest benefit of a 401k is the fact that it’s built with pre-tax dollars, you’ll be double-taxed on the money once you withdraw it in retirement as actual income. Again I ask: Where’s the benefit?
3. You’re risking your future for a (bad) short-term solution
Let’s say you’ve tried and failed to consolidate your credit card debt, have no friends or family to help you out, and don’t own a home to borrow against. You know you’ll be able to repay your 401k loan within 5 years, are confident you won’t lose your job in that time, and the double-taxation issue doesn’t bother you.
I still don’t recommend withdrawing, or taking a loan from, your 401k.
The money in your retirement account is there for one reason: to sustain you during retirement. A $2,000 credit card bill, an engagement ring, or a down payment on that house you can’t wait buy will pale in comparison to being 75 years old, unable to work and without any sort of nest egg.
Do not bet against your future.
In addition to the potential risk of retiring without enough to live on, you still will be losing money.
There’s a concept in personal finance called the “Time Value of Money”. Basically, a dollar today is worth more than the same dollar tomorrow, because today’s dollar can be used to build wealth for tomorrow.
If you pull your investment dollars today, you lose the magic of compound interest. You’re losing the potential profits from those investments, and all the compounding power that comes with.
If you take a loan, many 401k plans won’t let you contribute more to your account until the loan has been paid back. If you wait the full 5 years to replenish the funds, that’s potentially hundreds of thousands of future dollars you’ve thrown away.
How to avoid taking a 401k loan or 401k withdrawal
They say the best defense is a good offense, and the best way to avoid a 401k loan is to have a sufficient emergency fund. Set aside 3-6 month’s worth of expenses (8 if your job is unstable) in an easy to access cash account. If you’re ever in a dire situation, or you lose your job, this money should get you through.
If you truly don’t believe you can afford to fund both a savings account and a retirement account, opt for a Roth IRA instead of a 401k. With a Roth IRA, any money invested can be withdrawn at any time – tax and penalty free.
While you can’t withdraw the growth, the money you put in is yours to do with as you wish. I still don’t recommend this as the first choice because of reason #3 discussed above, but the consequences of a Roth IRA withdrawal are far less severe, and you won’t be digging yourself an even deeper hole just for some quick cash.
Don’t bet against your future
I’ll say it one more time: Your 401k plan is not a savings account. It is not “extra” income.
Any money you put into retirement needs to stay there until you actually retire.
Every dollar you invest into retirement is an investment into your future comfort, stability and ability to provide a good life for your family.
Withdrawing from or taking out a loan against your 401k is placing a bet on your future.
It’s a bet that paying off this one bill, paying for this one item, or getting you through this one bad season is worth having fewer dollars in the bank later on. It’s betting you need this money now more than you’ll need it later. It’s betting you’ll eventually make enough money that giving it all up now is worth it.
Please, don’t place that bet. Choose to protect your future instead.
Photo Credit: American Advisors Group
Have you ever considered taking out a loan or withdrawing from your 401k plan? What choice did you end up making? Leave a comment letting me know what happened!
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