The Pros & Cons of 401k Withdrawals

The negatives of a 401(k) withdrawal often outweigh the benefits.

The negatives of a 401(k) withdrawal often outweigh the benefits.

Your 401(k) plan is designed to help you save for retirement. When you take money out of your 401(k), you not only deprive yourself of future earnings but also owe taxes. Early distributions are hit with an additional penalty. However, if you absolutely need the money, getting it from your 401(k) might be your only option. If you can later pay the money back, you might even be able to avoid the taxes and penalties.

Access to Money

The biggest advantage of withdrawing from your 401(k) is having money. Everyone likes having more money in his pocket. If you take money out of your 401(k), you can pay your bills, buy a house or even take a vacation. While you originally allocated your 401(k) money for your retirement savings, it's still your money, and you can choose what you want to do with it. Although it might not be the textbook "right thing to do," having the money to take care of immediate needs is a definite advantage of a 401(k) withdrawal. Bear in mind that the IRS limits 401(k) withdrawals before age 59 1/2 to financial hardships, severance from employment, plan termination or death or disability. Your employer may have even more restrictive withdrawal policies.

Taxation

No matter what you use your 401(k) withdrawal for, you'll have to pay tax on what you take out. The money you put into a 401(k) has never been taxed, since you got a tax deduction when you originally contributed the money. Particularly if you are in a high tax bracket, withdrawing from your 401(k) can be costly. If you take a large distribution, you might even kick yourself up to a higher tax bracket.

Penalties

Even if you qualify for a hardship withdrawal before age 59 1/2, the Internal Revenue Service will penalize you for taking it. On top of the tax you have to pay, you'll owe another 10 percent as an early distribution penalty. As of 2012, if you are in the highest tax bracket your early 401(k) withdrawal will cost you 45 percent in federal taxes and penalties. With applicable state and local taxes you could end up losing over half of your distribution.

Diminished Savings

Whatever money you take out of your 401(k) is obviously not available for you at retirement. Since earnings grow tax-deferred in a 401(k), the amount you take out now could be worth considerably more at retirement, particularly if you are still young. Your plan might prevent you from making additional contributions for six months after your hardship withdrawal, so you will lose the benefit of those contributions as well.

Loans

If you intend to pay back the money you take from your 401(k), consider a loan instead of a withdrawal. The IRS allows you to borrow up to $50,000 or half the value of your account, whichever is less, although your employer may or may not allow loans. The benefits of a loan are that you don't have to pay taxes or penalties on it, and you pay back the interest to your own account.

About the Author

After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.

Photo Credits

  • Zedcor Wholly Owned/PhotoObjects.net/Getty Images