There are lots of smart financial moves you can make in your lifetime, but taking money out of your 401k plan prematurely isn't one of them. A 401k is designed for saving for retirement and to lower your present taxable income. If you take the money out before reaching age 59 1/2, expect to pay substantial penalties immediately and in the future. In other words, do it only as a last resort.
10 Percent Fee
If you take money out of your 401k before you reach age 59 1/2, you'll incur a 10 percent penalty right off the bat. Instead of getting $25,000 to put toward that new Benz you've had your eye on, you'll get a check for only $22,500. It may be tempting to use that lump sum distribution you get from your previous employer when changing job for a Hawaiian vacation. However, for your long-term financial health, the better move would be to roll it into an IRA or you new employer's 401k.
You'll also have to pay taxes on the withdrawal amount in the year you receive it. Assume you take a premature withdrawal of $10,000 and you're in the 28 percent tax bracket. That's another $2,800 you'll owe to Uncle Sam come April 15. If you're on the fence regarding your tax bracket, the premature distribution could conceivably push you into a higher bracket. Depending on your state of residence, you may also owe state income taxes on the money.
Once you take money out of your 401k, you lose the opportunity to earn continuing interest. These are potential earnings that you can never recover, even if you replace the money later. For example, if you were to withdraw $20,000, then replace it five years later, that's still five years that the $20,000 was not earning interest. Taking into account the concept of compound interest (interest earning interest) the bite taken out of your retirement could leave you quite hungry.
Fortunately, there are circumstances when you can withdraw money before age 59 1/2 without penalty. One way is to take a loan. You'll have five years to repay the money, and the interest rate is relatively low. However, that's still money that's not earning interest while it's on loan. Other circumstances where early withdrawals are permitted include cases of financial hardship, buying a first home, and paying for college or medical expenses.
Chris Joseph writes for websites and online publications, covering business and technology. He holds a Bachelor of Science in marketing from York College of Pennsylvania.