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Early 401(k) Withdrawals at a Young Age: What You Need to Know Thumbnail

Early 401(k) Withdrawals at a Young Age: What You Need to Know

Are you contributing to your employer’s 401(k) plan? Taking advantage of this retirement savings vehicle is a no-brainer when it comes to having an easy way to save money for retirement each month. The average 401(k) match nets out to be 4.3%, which may not seem like much, but with compounding interest, your savings can steadily grow as you contribute funds throughout your working years.1

Census Bureau research has found that about 80% of Americans are eligible to contribute to a 401(k) plan; however, only about 40% of employees actually do so.2 Not taking advantage of a 401(k) match is akin to leaving “free money” on the table. This low participation could be due to a lack of employee education about and awareness of 401(k) plan benefits. If you are unsure about the rules and stipulations associated with a 401(k) plan, consider hiring a financial advisor who can walk you through the details and help you become well-versed in the vehicle’s requirements.

According to one study, 51% of Americans have taken an early withdrawal, and Generation Z (58%) and millennials (48%) are more likely to take an early withdrawal than the older generations.3 If you have a decent amount of money saved, it can be tempting to withdraw your 401(k) funds sooner than originally planned. However, there are a variety of reasons why doing so may not be beneficial in the long run.

Overview of 401(k) Plans

Two benefits of a 401(k) plan are that they accept tax-deductible and tax-deferred contributions. This means that you’ll not only save on taxes but that you also won’t have to pay many taxes until you withdraw your money. However, you can only take advantage of these benefits if you follow specific 401(k) plan rules. 

In most cases, withdrawals from 401(k) plans are taxed as ordinary income. Most 401(k) plans are set up with the expectation that funds will not be withdrawn until the holder is at least 59½ years old, and early withdrawals incur a 10% early distribution penalty tax on the amount withdrawn. This is only one of the many disadvantages of withdrawing early from a 401(k) plan.

Disadvantages of Withdrawing 401(k) Funds Early

Withdrawing your 401(k) funds before you’re 59½ can practically eliminate the main benefit of a 401(k) plan: tax deductions. This is because there are several penalties attached to early withdrawals. As mentioned previously, any withdrawal is considered to be taxable ordinary income, which means you’ll be losing a significant amount of savings simply due to the timing of the withdrawal.

It’s worth noting that if you withdraw money while you are in a higher tax bracket than the one you will be in when you retire, you will pay a higher amount in tax when you withdraw. Additionally, taking your money out early prevents it from growing and multiplying, which is one of the main reasons for contributing to a 401(k) plan. While the immediate reward may initially seem worth it, you may sorely miss these funds when you reach retirement. Ultimately, the longer your money sits in a 401(k) plan, the more it will compound.

Early Withdrawal Exceptions

While there are exceptions to early withdrawal, it’s important to note that your withdrawal will still be counted as taxable ordinary income. However, if you meet one or more of the below exceptions, you will not have a 10 percent penalty to pay.

All early withdrawals count as taxable ordinary income; however, if you meet one or more of the below exceptions, you will avoid paying the additional 10% penalty.

You may be able to withdraw from your 401(k) early with minimal consequences if you: 

  • You have a disability. 
  • You were fired from your job when you were 55 or older.
  • You have significant medical expenses.
  • You have a qualified domestic relations order.
  1. https://www.investopedia.com/articles/personal-finance/120315/what-good-401k-match.asp
  2. https://www2.census.gov/foia/records/GideonMitchell_AEA2017Jan.pdf
  3. https://www.bankrate.com/retirement/retirement-savings-survey-november-2021/

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.