Early Withdrawal Pros & Cons
Whether an early withdrawal is right for you depends on your situation. To help you think about it, here’s a few pros and cons of making early withdrawals to consider:
- You can finance big expenses such as home repairs, medical bills or college tuition if you need the money.
- You can avoid taking on debt if you need to cover a financial emergency.
- You’ll pay taxes and penalties on your withdrawal, so you’ll likely get 70% or less of the money you take out.
- When you withdraw money from your 401(k), you lose the growth potential that can come with keeping your money invested.
Should I take a 401(k) loan instead of a withdrawal?
If you don’t want to make a 401(k) withdrawal, you may have another option: 401(k) loans.
A 401(k) loan is when you borrow money from your 401(k) account. This can be useful because 401(k) loans are usually quick to apply for, have flexible cost and repayment terms, and usually don’t have a major impact on your retirement savings.
There’s a catch: the maximum you can withdraw is 50% of your account balance, or $50,000 — whichever amount is lower. Like other loans, you’ll have to repay whatever amount you withdraw plus interest. In this case, the interest is to cover the assumed growth of your 401(k) if you had not withdrawn the amount of your loan. This might seem confusing, but ultimately you’re just repaying yourself. Make sure you know how to check your 401(k) account balance to confirm what that number looks like to you.
Impact of the CARES Act
As a result of the COVID-19 crisis, many people have experienced temporary financial hardships and emergencies. Congress passed the CARES Act to allow more flexibility when making an early withdrawal to cover your financial needs. The CARES Act eliminates the 10% early withdrawal penalty as long as you meet certain requirements. These include being diagnosed with COVID-19, or experiencing financial consequences from a lost job or reduced hours. In most cases, one-third of the money you withdraw will be counted as taxable income for each of the next three years. If you need to make a withdrawal, check if you qualify under the CARES act to avoid an early withdrawal penalty.
401(k) withdrawal vs. rollover
If you’re starting a new job, chances are you’ll find yourself with some paperwork that has the words “401(k) rollover” stamped all over it. A 401(k) rollover is a transfer of money from one retirement account to another. It’s different from a withdrawal — because the money is staying in a retirement account, you typically won’t pay taxes or penalties on rollovers.
A 401(k) rollover can happen after you leave a job and choose to move your employer-sponsored account to a new 401(k) or IRA (either a pre-tax traditional or after-tax Roth IRA). Don’t worry, taking money out of a 401(k) during a rollover transaction isn’t taxable, but you will need to report it on Form 1099-R. You can roll over most distributions, but there are a few exceptions. It’s helpful to know what to do with your 401(k) when you change jobs.
Conclusion: withdrawals are doable, but can cost you
In an ideal world, you won’t need to cash out your 401(k) and you’ll leave your retirement savings contributions alone until you reach retirement age. However, there are scenarios when you may consider a withdrawal before reaching the age of 59 ½. Normally you should expect to pay both income tax and a 10% penalty on these early withdrawals — but there are situations when you can avoid that penalty. Keep in mind that any withdrawn money also loses the opportunity to grow for you. For these reasons, most financial advisors suggest 401(k) withdrawals as a last resort and commonly recommend 401(k) rollovers instead.