The High Price of a 401(k) Withdrawal

Life has a way of throwing curve balls at us. And they’re great at draining us of our money—especially if we’re not prepared. You’ve heard of Murphy’s Law, right? Anything that can go wrong will go wrong. Murphy is rude. He doesn’t even knock when he shows up—he just kicks down the door!

The coronavirus pandemic is the biggest financial crisis that a lot Americans have ever seen. If you’re scared right now about emergency expenses or paying down debt, you might be tempted to take money from your 401(k), especially considering the new loopholes in the CARES Act that Congress recently passed.

But is a 401(k) withdrawal a good idea? Let’s jump into the details to find out.

401k Early Withdrawal Penalties

If you take money out of your traditional 401(k) before age 59 1/2, you’ll get hit with two big bills when you file your next tax return:

  1. Income taxes on your withdrawal
  2. 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 $2,000 for that 10% penalty. In the end, you’re only left with $13,600 of your original $20,000. That’s outrageous! There are better ways to pay the bills.

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 I mean: Let’s say you left that $20,000 alone for 25 years and it averaged a 10% annual growth rate in a good mutual fund. That $20,000 would eventually turn into more than $240,000, 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. 

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.”1  Hold up . . . is that the IRS making jokes?

These six circumstances qualify for a hardship withdrawal:

  1. Medical expenses 
  2. Costs relating to the purchase of a principal residence
  3. Tuition and related educational fees and expenses
  4. Payments necessary to prevent eviction or foreclosure (of your primary residence)
  5. Burial or funeral expenses
  6. Certain expenses to repair damage to your principal residence2

Also, I should mention here that the SECURE Act, which was passed in December of 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.3

Keep in mind that each retirement plan varies, and your employer is not required to make hardship withdrawals an option for your plan. For example, some may not allow for tuition expenses, and others do. Check with your HR department if you have questions about your specific plan.

Hear me on this, people: 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.

401(k) Withdrawals Under the CARES Act

The CARES Act, a federal stimulus package that was signed into law on March 27, created a new type of “hardship withdrawal” to help people who have been hard hit by the coronavirus pandemic. Those who have lost a job due to the virus, are sick, or are caring for a sick spouse or dependent can withdraw from their retirement accounts without paying the 10% withdrawal penalty. Once again, you’ll still have to pay income taxes on the amount you withdraw, although there’s flexibility in the repayment—you can pay the taxes over three years if needed.4

You can take up to $100,000 for these types of withdrawals:

  • 401(k) distribution
  • 401(k) loan
  • IRA withdrawal

The difference between the 401(k) loan and distribution is that with the distribution, you just bite the bullet and pay the taxes now, but with a loan, you’re supposed to “repay yourself” eventually, and therefore you avoid paying taxes. Typically, a 401(k) loan only allows borrowers to take up to $50,000, but the CARES Act doubles the normal amount for the next six months.

Should You Withdraw Money Early From Your 401k?

The answer is big no: It’s almost never the right decision. 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 fees and penalties. 

We’ve already been over this, but let me remind you one more time: 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.

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. 

I’m a big sports guy, so let me give you an analogy from football. Taking money out of your 401(k) is like throwing a Hail Mary pass—it’s a last-ditch attempt to solve a desperate problem. That’s not how champions play, people! 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, I understand—a big, unexpected expense or a job loss will make you feel overwhelmed, frightened and trapped. So, you need to hear this: You do have options, and they’re much better than robbing your retirement fund. It might take some sacrifice, but if you stay focused, I know you can overcome this.

Instead of taking money from your 401(k), I 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. Now, if you’re taking money from your retirement to pay for school for your child, then it’s time for some real talk. You don’t have to pay for Junior’s dream school. You and your child have options to get them through college debt-free that don’t involve stealing from your retirement.
  • Work out a payment plan. Whether you owe money to the IRS or to a lender, call them up and explain your situation. See if you can break out that big amount into smaller payments over a set period of time.
  • Ask for help from family or friends. No, I’m not recommending that you ask them for money, but you might be able to get some nonmonetary 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).

Let’s go back to that football analogy. If you want to play like a champion, you need a 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.

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