The Extremely High Costs of Taking Early Withdrawals from Your 401(k)

Due to rising costs and a troubled economy, a record number of Americans are dipping into their 401(k) plans to stretch their budgets. While it may be unavoidable for some, it’s essential to understand what early withdrawals can cost in terms of reduced retirement savings.

Most people are aware that early withdrawals from a 401(k) plan trigger not only ordinary income taxes but also a 10% penalty. While there are exceptions to the 10% penalty rule, the cost of early withdrawals is not just limited to taxes and penalties. The most significant cost is the lost opportunities to generate future returns. Money withdrawn early from a 401(k) means less capital working to compound earnings.

The worst-case scenario is withdrawing funds during a market decline. Not only does it result in less available capital, but also a permanent loss of capital. That’s true whether you withdraw the funds from your 401(k) account or cash out of your investments to avoid further market declines. It may feel better at the moment to be free of frightening market volatility, but the damage to your long-term investment performance may be irreparable.

Avoiding the 10% Penalty

• There have always been exceptions to the 10% penalty rule. The IRS will waive it under any of the following circumstances:
• You take "substantially equal periodic" payments. If you take a series of equal payments annually from your account for at least five years or until age 59½.
• You leave your job in the year you turn 55 or later.
• You become disabled.
• You get divorced.
• You or your spouse birthed a child (up to $5,000 per account).
• The IRS grants relief if you are the victim of a disaster.
• You are a military reservist called to active duty.

In addition, the recent enactment of the SECURE Act 2.0 grants all 401(k) accountholders the opportunity to take an early withdrawal of $1,000 a year for a self-proclaimed emergency starting in 2024.

You can also borrow up to $100,000 from your 401(k), but it has to be repaid within five years to avoid the 10% penalty.

The problem is it has become too easy to take money out of a 401k), yet, in many cases, it can be difficult to get the money back in, resulting in a permanent reduction of your retirement savings.

The Real Impact of Early Withdrawals on Retirement Savings

While taxes and penalties are the obvious costs of early withdrawals, they pale compared to the lost opportunity for compounding returns over time. For example, if you withdraw $20,000 from an account averaging a 6% return at age 37, there could be $102,000 less available for your retirement. That’s a significant amount of money.

If you wait until age 47 to withdraw the $20,000, you could have $56,000 less in your retirement fund—almost three times the withdrawal amount.

Missing the Best Days of the Market

Worse, if you cash out of the market during a market decline, you will likely miss out on some of the best returns in the market, permanently hurting your long-term investment performance.

Consider the last major stock market crash in 2020. During the worst periods of that steep decline, two days had more than a 9% gain in the S&P 500. Both days were among the top ten return days in the market’s history. The first occurred on March 13, just one day following the second-worst return day in twenty years. The second 9% burst occurred the day after the market crash bottomed on March 23. The market surged 40% from the March bottom in the following months.

If you abandoned the market in early March, as many investors did, and missed the five best return days when it rebounded 40% over the next six months, your portfolio would have lost nearly 30%, which would have been locked into your investment performance.

The bad news is that when you eventually get back into the market, you will need to generate 42% in returns just to recover from your 30% loss. And, without the benefit of some of the best days in the market, it could take as many as four years to get there.

Seek Financial Guidance First

In some cases, taking an early withdrawal may be unavoidable. If you need the money and have exhausted all possible alternatives, you need the money. However, it’s critical to understand its implications on your retirement goals so you can properly adjust your plan. Your financial advisor can help you understand its impact on your retirement and help you consider ways to minimize the damage.