You’ve probably heard of Murphy’s Law, right? It says that anything that can go wrong will go wrong.
If Murphy has set up camp in your spare bedroom and you’re not sure how you’re going to cover those emergency expenses or pay down your debt, we get it—it can be frightening. If you don’t have much in savings, you might even be tempted to take money from your 401(k).
But here’s the deal: Taking an early 401(k) withdrawal is one of the worst moves you can make for your long-term financial future. We’re talking a one-two punch of taxes and penalties that’ll knock you out!
And on top of that, you’ll miss out on all the investment growth that money could have made if those funds had stayed in your 401(k). You’d be robbing your future self of a lot more money than what you withdraw today!
Let’s dive into what taking an early 401(k) withdrawal really means for you and your finances. That way, you can see for yourself what a raw deal it is.
What Are 401(k) Early Withdrawal Penalties and Taxes?
If you take money out of your traditional 401(k) before age 59 1/2, you’ll get hit with two big bills. First, you’ll likely have to pay income taxes on your withdrawal. And on top of that, there’s an early withdrawal penalty of 10%.
Let’s say you make $60,000 a year and you withdraw $20,000 from your 401(k) to pay for medical bills. You’re in the 22% tax bracket, which means that Uncle Sam pockets $4,400 of your 401(k) money for income taxes and another $2,000 for that 10% penalty.1
In the end, you’re only left with $13,600 of your original $20,000. That’s outrageous! That’s like taking money out of an ATM machine and then someone swoops in and immediately runs off with one-third of your cash. No thanks! There are better ways to pay the bills and deal with emergencies.
But taxes and penalties are just the beginning of the money you’ve lost. You’re also robbing from your future self.
Here’s what we mean: Let’s say you left that $20,000 alone for 25 years and it averaged an 11% average annual rate of return in good growth stock mutual funds. Without putting in another dollar, that $20,000 could eventually turn into more than $300,000—and you’d never even have to lift a finger!
Here’s the reality: Your 401(k) is a retirement account that’s designed for long-term wealth building. It’s not supposed to pay for emergencies or be your college tuition fund for little Suzy.
Why You Shouldn’t Cash Out Your 401(k)
If we haven’t made it clear already, the answer to whether or not you should take money out of your 401(k) early is a big, fat no! It’s almost never the right decision to take an early 401(k) withdrawal.
There are three reasons why you shouldn’t turn to your 401(k) to pay down debt or emergency expenses:
1. You’re paying a fortune in taxes and penalties.
We might sound like a broken record here, but it’s important: When you take an early distribution from your 401(k), you’ll pay Uncle Sam income taxes on that money plus a 10% withdrawal fee. Ouch!
2. You’re robbing your retirement dreams.
The two most powerful forces in all of finance are time and compound growth. Think of saving for retirement like growing a tree. It takes decades for most trees to reach full height. If you drain your 401(k) now, it’s like uprooting a tree—you’ll have to start over again with a tiny little seed.
3. You’re executing a bad financial game plan.
Taking money out of your 401(k) is like throwing a Hail Mary pass when you don’t need to. It’s a desperate attempt to solve an immediate problem . . . and chances are it won’t even work!
Market chaos, inflation, your future—work with a pro to navigate this stuff.
That’s not how champions play. They win by consistently executing a proven game plan over time that sets them up for victory.
The only time you should withdraw money from or cash out your 401(k) is to avoid bankruptcy or foreclosure—and that’s only if you’ve exhausted all other options, like taking on extra jobs and a short sale on your house.
You Have Better Options Than Draining Your 401(k)
Listen folks, we get it—an unexpected expense or a job loss will make you feel overwhelmed and trapped. Emergencies can knock the breath out of you and leave you feeling desperate enough to turn to your retirement savings as a quick fix.
But you need to hear this: You do have other options, and they’re much better than dipping into your retirement fund. It might take some sacrifice, but if you stay focused, we know you can overcome this.
Instead of taking money from your 401(k), we want you to try one or all of these options:
Go into conserve mode.
If you’re in a true financial crisis, it’s time to cut all unnecessary spending: the gym, entertainment and online shopping. It might even be time to sell your car. Get on a budget and take control of your money.
Work out a payment plan.
If you’ve fallen behind on paying your bills or still owe Uncle Sam some taxes, it can be tempting to dip into your 401(k) to make the problem go away. But that’s only going to cause you more problems later.
Whether you owe money to the IRS or a lender, call them up and explain your situation. Chances are they’ll be open to setting up a payment plan that’ll break up that big amount into smaller payments over a set period of time.
Ask for help from family or friends.
No, we’re not recommending that you ask them for money, but you might be able to get some other forms of help. Maybe you could save childcare expenses by asking a parent to watch your kids. Or if you’re in a really desperate place, like being unable to pay rent, you could move in with family until you’re back on your feet.
Take on extra work.
It’s a temporary sacrifice that sets you up for long-term success. Debt keeps you trapped. And borrowing from your 401(k) robs you of your future. Do what you have to do right now to keep from adding to your debt or draining your 401(k).
If you want to be better prepared when future emergencies and surprise expenses pop up, you need to follow a proven game plan for your money. It’s called the 7 Baby Steps—the proven plan for getting out of debt and building wealth. If you take these steps, you’ll put yourself in a position where you never feel tempted to withdraw from your 401(k) again.
Ramsey Solutions is a paid, non-client promoter of participating pros.
What Is the Difference Between a 401(k) Withdrawal and a 401(k) Loan?
The biggest difference between a 401(k) withdrawal and a 401(k) loan comes down to how they’re taxed and the type of risk involved.
When you take an early 401(k) withdrawal, that money will be treated like ordinary income. That means you’ll have to pay taxes on that money now (along with that hefty early withdrawal penalty we’ve already mentioned). You’re not obligated to put the money you took out back into your 401(k)—it’s yours to do whatever you want with it.
But 401(k) loans are a different beast entirely (and there isn’t much beauty to speak of, folks). Here’s how a 401(k) loan is different from an early 401(k) loan withdrawal.
1. A 401(k) loan is debt, just like any other loan.
With a 401(k) loan, you’re just borrowing the money from your own account. Like any other loan, you have to pay that money back—in this case, back into your 401(k)—over a certain period of time, plus interest (which goes into your 401[k] too).
The longest repayment period the government allows for 401(k) loans is five years (there’s one exception—if you use the loan to purchase your primary residence).2 That’s five years you’ll be in debt to your future self instead of letting that money grow in your retirement account.
2. There are no tax benefits for 401(k) loan repayments.
Since the money you borrow from a 401(k) isn’t treated like ordinary income, you won’t owe any taxes on it or have to pay an early withdrawal penalty. Sounds great, right?
But here’s the catch: Your loan repayments will be taxed not once, but twice. Unlike traditional 401(k) contributions, which are tax-deferred and lower your taxable income, you won’t get a tax break for your loan repayments. Instead, that money gets taxed before it goes into your 401(k) and again when you take the money out in retirement.
3. If you lose your job, you might have to pay back your 401(k) loan quickly.
The really scary part about taking out a 401(k) loan is what happens if you lose your job. Because if you get fired, laid off, or decide to leave your job and you still have a loan balance, you’ll have to repay the entire balance back into your 401(k) by the following year’s tax filing deadline (Tax Day).3
If you don’t pay back the balance in time, your loan will be in “default” and the remaining balance will be treated like an early withdrawal. That means you’ll owe income taxes on whatever is left and you’ll have to pay a 10% withdrawal penalty (if you’re under age 59 1/2). So essentially, you’re getting in huge trouble for not paying yourself back in time. What a raw deal!
When you take out a 401(k) loan, you’re not only putting your nest egg and retirement dreams at risk—you’re also opening yourself up to some real financial pain in the present. It’s a really bad idea, folks.
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What About 401k Hardship Withdrawals?
A hardship withdrawal is a special circumstance when the IRS allows you to take money out of your 401(k) without the 10% withdrawal fee (although you’ll still have to pay income taxes).
According to the IRS, a hardship withdrawal applies to people in an “immediate or heavy need.” These circumstances apply to you, your spouse or your dependents.
And by the way, the IRS makes sure to throw this qualifier in there: “Expenses for the purchase of a boat or television would generally not qualify for a hardship distribution.”4 Uncle Sam needs to work on his jokes.
What kind of situations qualify as a hardship?
These six circumstances qualify for a hardship withdrawal:
Medical expenses for you, your spouse, or dependents
Costs relating to the purchase of a principal residence (like a down payment)
Tuition and related educational fees and expenses for you, your spouse, dependents, or nondependent children
Payments necessary to prevent eviction or foreclosure of your primary residence (Regular mortgage payments don’t count as a hardship)
Burial or funeral expenses for a parent, spouse, child, or other dependent
Certain expenses to repair damage to your principal residence5
Also, we should mention here that the SECURE Act, which was passed in December 2019, gave new parents the option to withdraw up to $5,000 penalty-free to pay for birth or adoption expenses for a new child. And the SECURE 2.0 Act requires that those distributions be repaid to the plan within three years.6,7
Keep in mind that each retirement plan varies, and your employer isn’t required to make hardship withdrawals an option for your plan. For example, some may not allow for tuition expenses, but others do. Check with your HR department if you have questions about your specific plan.
Even if you qualify for a hardship withdrawal, it’s a bad idea to raid your own nest egg. You’ll still have to pay income taxes, plus you’ll miss out on compound growth of the money you take out. There are better solutions you can discuss with your financial advisor.
Stick With Your Retirement Plan
Life has a way of throwing the unexpected at you. That’s why it’s always a good idea to have a financial advisor you trust in your corner. With our SmartVestor program, you can connect with an investing pro who’ll help you make smart decisions about your future and stick with your investments for the long term.
You’ve worked hard to build up your 401(k). Don’t let the stress of credit card debt, a job loss, or going through a divorce steer you toward an early withdrawal or 401(k) loan. You’ve got options, and you got this!
This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.
