Negative Impact of Taking an Early 401k Withdrawal

Economic times are still rough after the global financial crisis and it might be tempting to take money out from the popular 401k retirement plan. There are consequences to the early 401k withdrawal however and not in the positive way. While short term financial troubles can make a person forget about the long term consequences, it is essential that the individual consider the negative impact that such an action will have on the future.

Tax Payments

The money that has gone into each 401k retirement plan has not been taxed. When an individual decides on an early 401k withdrawal, they will have to pay taxes on those funds. The amount of taxes is determined by the amount that is withdrawn. There are regulations stating the maximum withdrawal as being 50% of what has already been contributed. Retrieving this percentage has higher consequences than just the tax level however.

Distribution Penalty Tax

Individuals desiring an early 401k withdrawal also must be over 59.5 years of age or they will incur the distribution penalty tax. This is valued at 10% of the amount of your withdrawal. There are exceptions to this rule.

This tax will be exempted in the case that the person becomes disabled, the position of employment has been terminated at an age after 55, or the withdrawal is in a smaller amount that is permitted but is being used to pay medical expenses. This tax is one negative impact of the early withdrawal that can be avoided under special circumstances and is something that an individual may want to consider in deciding whether or not to wait.

Actual Retirement Funds

One major negative impact of the early 401k withdrawal is the actual amount of retirement funds received once the individual has stopped working. It is much more difficult for a retiree to find adequate source of funds and when the funds are removed from the 401k plan, there is less for the individual to live on in the future. The retirement plan is specifically for making the financial part of life easier for the person who no longer works. Taking the funds early defeats this purpose unless the money is replaced.

Interest Rates

The money that is in the 401k retirement fund gathers interest over time. Larger amounts of money placed into the plan means that there is also more interest collected. In the event that a person does make an early withdrawal, there are fewer funds to expand for the future. The interest on a few dollars may not seem drastic but when it is calculated on thousands of dollars for a number of years, these figures really add up.

Calculating Penalties

To fully understand the amount of penalties that a person would have to cope with in going through an early 401k withdrawal, there are online tools they can use. Such things as the financial calculator at CalcXML can be of great assistance. Some of these calculators only check the interest rate lost or the actual fees paid but there are many that calculate the complete negative impact.

These tools ask for the basic information such as the number of years before retirement, the annual income bracket and the marginal tax bracket. Other questions include the amount of money desired to withdraw, the annual before-tax return on the 401k, and other similar things.

An Alternative to the Early 401k Withdrawal

There is an alternative for individuals that need extra funds but that don’t wish to make an early withdrawal. There is the option to take out a loan on the 401k. There are still some drawbacks to this alternative but it means that the funds will go back and it won’t be a complete loss. The money is given in the form of a loan, and the repayment schedule is set. Until this amount is repaid, a person cannot add money to the plan.

Aside from having to repay the money, there are other drawbacks. The regular take-home pay for the individual is reduced while in repayment and there are high fees charged for either non-payment or late payment on this plan. Individuals that can definitely make the payments and are not of age to withdraw money from the fund without penalties may want to consider this option if they have no other.

Making the Choice

The decision of whether or not to make an early 401k withdrawal is a very important one that takes a lot of planning. A person should consider all of the negative consequences and the possible alternatives before making that final decision.