Saving for retirement through an employer’s 401(k) plan is a great way to invest in yourself – both for today and for your future. With each contribution to your plan, you essentially pay yourself (rather than Uncle Sam) and allow those payments to stay invested in the market, where they have the potential to grow exponentially and finance a comfortable retirement for you in the future. However, early withdrawals from these plans prior to your full retirement age of 67 can have significant impact on your long-term retirement security and your shorter-term needs and goals.
The way 401(k) plans work, contributions up to the legal maximum ($19,500 in 2021 or $26,000 if you are older than 50) are made with pre-tax dollars that reduce your taxable income in the years of contribution. Those savings grow tax-deferred and may be withdrawn without penalty after you reach age 59½. At that point, you will pay federal and state income taxes on your distributions at your ordinary income tax rate, which, during your retirement, may be lower than the rate you pay during your prime earning years.
To discourage workers from using their 401(k) savings as piggy banks to pay for all of life’s unexpected scenarios, the IRS generally imposes income taxes and a 10 percent penalty on withdrawals taken by account owners younger than 59½. However, due to the immediate and lasting impact of the COVID-19 pandemic, the government lifted many of the restrictions on early 401(k) withdrawals in 2020, including the ability to withdraw up to $100,000 or 100 percent of their vested account balances without penalty, to pay the related tax liabilities and reinvest withdrawn amount over a three-year period. Now, in the midst of 2021, the early withdrawal restrictions are back in place, and 401(k) savers must recognize the dire consequences of taking hardship withdrawals or loans from their 401(k) plans.
Just because you can tap into your 401(k) savings does not mean you should. For example, if you take a $10,000 withdrawal from your 401(k), the actual amount you would receive after paying taxes and penalties would be approximately $6,300. More importantly, you will lose the benefits of compounding interest and long-term growth opportunities. This is especially true if you make an early withdrawal when the market is down. In such a scenario, you may lose the ability to participate in a market rebound and your entire retirement plan will be impacted.
To avoid putting your retirement security at risk, you should first aim to have a pool of emergency savings with at least six months of expenses to help you get through difficult times. Next, consider other options for creating cash flow, including a bank loan, a home equity line or credit or even the sale of long-held securities, which are taxed at a lower rate than ordinary income and will not impact your longer-term retirement plans. Cashing out a 401(k) prematurely could cost you a steep price if you do not proceed with caution.
About the Author: Olga Ismail is a retirement plan consultant with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
Provenance Wealth Advisors (PWA), 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Olga Ismail is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of PWA and not necessarily those of Raymond James. You should discuss any tax or legal matters with the appropriate professional. The information contained in this report has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete.
401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed. Future investment performance cannot be guaranteed. Matching contributions from your employer may be subject to a vesting schedule, please review your retirement plan documents or consult with a financial professional for more information.
Posted on August 12, 2021