Last Updated on November 14, 2023 by Ben
Are you thinking of tapping into your 401(k) or cashing it out? Think again! Not only will you be hit with hefty taxes and withdrawal penalties, but you’ll also miss out on the long-term benefit of compound growth. It’s no wonder why many millennials later regret raiding their retirement early.
The Most Common Reasons for Cashing Out a 401(k)
People may cash out their 401(k) for various reasons. Common motivations include needing money during a financial emergency, wanting to move the funds into a different retirement account, feeling pressured to make ends meet, or wanting to invest in something else. Withdrawal from a 401(k) should be made with thought and care, as it can have long-term consequences and lead to tax penalties. Before cashing out, consider other options and explore the ramifications of such decisions.
So why are people doing it? Here’s a look at some of the most common reasons we hear for cashing out a 401(k)—and why it’s almost always a bad idea.
- Changing or Losing Your Job
Imagine this: Your employer summons you to his office. You leave by closing the door. I’m sorry, but we have to let you go. Those are the last words anyone wants to hear.
You should grab that money and run if you have little money saved in your 401(k) when you leave work. You pack up your desk and are suddenly out of a job. But in actuality, even a modest payout can significantly influence your retirement savings.
Look at Joe for a moment. After working for a few years, he recently accepted a new position at 25. He chooses to withdraw $4,500 from his 401(k) to cover the cost of his move and furnish his new home. It’s only $4,500, after all.
It appears to be even less. First, around 25% is kept by Uncle Sam for income taxes. Then Joe is charged a 10% early withdrawal penalty, which brings his $4,500 down to just $2,925.
Even worse, Joe will only profit from compound growth’s long-term advantages. What if, as he ought to have done, he had rolled his 401(k) into an IRA when he left his job? Without making any additional deposits, Joe’s account could have increased to more than $200,000 over the following 40 years. What a costly error that was!
- Cost of Education
Perhaps instead of withdrawing your entire 401(k), you want to use a portion of your savings to pay for your master’s degree by returning to school. Or you may have a teenager about to graduate from high school, and you still need to start your college fund, and it’s for a good purpose.
When parents and young employees don’t have enough money to cover college expenditures, they frequently turn to their retirement funds because most 401(k) plans allow you to borrow up to 50% of your account’s value up to $50,000. But just because something is widespread doesn’t imply it’s intelligent!
When you borrow from your 401(k), there are some unpleasant conditions (k).
The following are a few effects:
- You must initially repay the loan amount you received plus interest.
- While loans are repaid with after-tax monies, your employer 401(k) investments are pre-tax, so it takes longer to accumulate the same amount.
- You have a set amount of time to repay your loan to avoid taxes and penalties.
- You must repay the entire loan debt by the due date of your federal income tax return if you quit your job for whatever reason.
There are several drawbacks to take into account. The final line is that your retirement funds should come before paying for your or your children’s college.
Now, don’t get me wrong: higher education is crucial. But the truth is that by picking an affordable university, working part-time, and applying for scholarships, you or your child can attend college without incurring any debt. I frequently converse with those who practice it. The bottom line: You have choices when it comes to your education!
Retirement is a whole different situation. You will rely mainly on the money you have saved in retirement accounts to cover your basic living expenses, so borrowing from your 401(k) puts you at risk (k).
Making your retirement a priority is not self-serving; it is a wise financial move for the future.
- Making a Major Investment
This one, though, really enrages me. I’ve spoken to far too many people who emptied their 401(k) or IRA to finance a kitchen renovation or a wedding, only to regret it later.
In fact, according to a recent survey, 2 out of 10 Millennials who plan to purchase a home anticipate using retirement funds to help pay for the purchase. Even worse, roughly a third of Millennials who have purchased homes in the past three years did so by borrowing funds from their retirement savings.
- Getting Rid of Debt
Okay, so you might think it would be so simple to pay off your debt in one fell swoop when it feels like you are being crushed under the weight of all your student loans, vehicle loans, and credit card bills. It is especially true if you look at your 401(k) money.
We comprehend. We want you to pay off your debt as quickly as possible. Your 401(k) is different than the solution, though. We’ve already demonstrated how taxes and penalties will cause many of your sacrificed savings to vanish into thin air. Additionally, you’d only create a more significant role in retirement savings.
It simply isn’t worth it, I assure you. Instead, we want you to focus and adhere to your plan. Maintain your debt snowball strategy and pay off your obligations one at a time. You’ll soon be debt-free and prepared to continue working toward your dream of retiring!
How to Avoid Cashing Out Your 401(k)
Retirement is the only reason for having a 401(k). Taking money out of your 401(k), even once, can be highly detrimental to your future retirement security. That’s why it’s essential to have an emergency fund with 3–6 months of expenses saved up before investing in a 401(k) or any other retirement account. If an emergency arises, you don’t have to resort to taking money from your retirement savings. Additionally, everyday expenses like vacations or renovating a kitchen should not be paid using your 401(k) funds. Instead, open up a “sinking fund” and set aside money each month until you can pay for them with cash. The only exception is if bankruptcy or foreclosure is imminent, and as always, remember that your 401(k) is off-limits until retirement.