Why You Should Resist the Temptation To Cash Out Your 401(k) Early
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In recent years, America's major stock market indexes, including the Dow Jones industrial average, S&P 500, Nasdaq composite index and Nasdaq 100, have all hit record highs. For some investors, it might be tempting to tap into your 401(k) to help pay down debts, purchase a home or take a once-in-a-lifetime vacation. However, doing so could seriously cost you, both now and in the future. Two of the main disadvantages of cashing out a 401(k) early can be implications on taxes and penalties, and the loss of potential future gains.
Taxes and Penalties
Unless your 401(k) withdrawal meets the requirements of a few exceptions permitted by the IRS, such as paying federal taxes owed after the IRS seizes the 401(k) account or becoming totally and permanently disabled, you'll pay a 10% penalty, plus, any applicable taxes on the withdrawal. Any amount withdrawn before you reach age 59 1/2 will be treated as ordinary income, potentially putting you in a higher tax bracket.
If you make any income-based payments, like student loans, taking an early 401(k) withdrawal may increase your taxable income for the calendar year. This may cause these income-based payments to rise until you file your next income tax return.
For example, if you take a $10,000 early 401(k) withdrawal and you are already in the 22% tax bracket, you may bring in only about $7,200 after paying a $1,000 IRS penalty, plus, a 22% tax rate on the remaining $9,000. Those in higher tax brackets, paying a 37% tax rate, could end up with as little as $5,670 from their $10,000 withdrawal after paying the penalty and income tax.
Loss of Potential Future Gains
The other way an early 401(k) withdrawal might cost you is the potential loss of future investment earnings. Leaving money in your 401(k), instead of withdrawing it, might help you earn more for your retirement. However, investing involves risks, including the possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Contributions to a 401(k) are limited for each tax year, depending on a person's age. In 2022, the limit is $20,500 for those under 50. It may be harder to make up for any withdrawal by contributing more in the future. The annual catch-up limit is $6,500 in 2022 for those 50 and older. When you factor in the potential of investment growth, a relatively small withdrawal could wind up costing you tens of thousands of retirement dollars.
It's tempting to cash out your 401(k) early, especially when the stock market indexes hit an all-time high. It's best to speak with a financial advisor and make sure these decisions align with your long-term financial goals before you do.
Talk to a Financial Advisor
Financial advisors with BECU Investment Services are here to help. Our team will take the time to get to know you, understand your goals and implement a financial and investment strategy that's appropriate for you. Set up a complimentary consultation or call 206-439-5720.
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*The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors. The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market.
The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index. The NASDAQ-100 (^NDX) is a stock market index made up of 103 equity securities issued by 100 of the largest non-financial companies listed on the NASDAQ. It is a modified capitalization-weighted index. It is based on exchange, and it is not an index of U.S.-based companies.