If you’re thinking about taking an early withdrawal from your 401(k)

New legislation eliminates penalties for some early withdrawals from your 401(k). However, just because you can doesn’t mean you should.

UPDATE: This legislation has expired as of the end of 2020. Penalties will apply again for early 401k withdrawals.

These are scary times.

When else in most people lifetimes have you thought to yourself: “If I get too close to certain people, will I die?

There have been small glimmers of help for the average worker, inadequate as they might be.

Specifically, the CARES Act, which has some provisions available to help, at least temporarily, the struggling worker.

While the details of the CARES Act can be found in many places (here’s a good link for the higlights), I wanted to highlight one of the provisions that you may be tempted to take advantage of.

It involves reduced penalties for early 401(k) withdrawals.

The average 401(k) balance for someone around 40 years old is $61,238, according to a recent study. Right now, you may be tempted to see that pile of money as an opportunity.

But before you hit that “ATM”, there are some things to consider.

What changed?

Before the world changed, 401(k) withdrawals, at least those that happened before the age of 59 1/2, were generally penalized at a 10% rate, and also treated as income, meaning that you had to pay taxes on it.

So, a 40 year old who wished to withdraw $10,000 from their 401(k) would pay a $1,000 penalty, and then be taxed at their income tax rate. Assuming a fictitiously round tax rate of 25%, that means that this $10,000 withdrawal would turn out to be a measly $6,500, a loss of a third. (This is, of course an estimate.)

No more direct penalty

Now, because of the CARES Act provisions, if you can show that you have been affected the current pandemic, you may be able to be forgiven the 10% penalty.

You’ll still have to pay income taxes just like you would normally, so your money isn’t free. But in our previous example, our 40 year old friend would now get $7,500.

So the first myth to dispel: it’s not free money.

It is money though. And that can be tempting if you’re in dire circumstances.

So here are some things to keep in mind:

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You are not going to put that money back in

Let’s be honest, any money you take out, you’re very unlikely to put back. Sure, you might continue to contribute to your 401(k) after all this is over, but that’s different money.

And, depending on how much you take out, you might not even be able to put it back. There are contribution limits on 401(k)s after all, and if you withdrawal, say, $100,000, you can’t just take $100,000 out of your paycheck (even if your paycheck was that high).

So this means that the money you have saved for retirement is going to be reduced.

(And let’s not even talk about loans from 401(k)s. Please just don’t.)

How much will you really lose?

Let’s continue with that $10,000 withdrawal idea for our 40 year old friend.

Let’s assume that this person plans to retire at age 67, which is nominally the year we now choose to call “normal” retirement.

What will happen to that $10,000?

If it is withdrawn from the 401(k), $7,500 will be spent more or less today, keeping a person or family afloat of the time being.

But what if that $10,000 is not withdrawn?

In ten years, that $10,000 will be worth between $14,000 and $22,000 (assuming an average annual market return of 4-8%).

In twenty years, that $10,000 will be worth upwards of between $22,000 and $49,000.

And by age 67, doing nothing with that $10,000 will make it worth between $29,000 and $86,000.

$10,000 over time in a 401(k)

And you know, of course, that this is only $10,000. you can add a zero to all these figures if you want to talk about withdrawing $100,000, the maximum you can under this CARES Act provision.

What else can you do?

A withdrawal of money from your retirement plan should definitely be thought of as a last resort. It’s available, but only after you’ve explored all other options.

What other options do you have if you need money or help now?

  • Stop all unnecessary spending. Yes, you may need to redefine necessary. It may be time to cancel some subscriptions and bills.
  • Call your providers and negotiate. Can you get a discount on your bills? Probably.
  • Pause your student loans. If you have them, this is an option at the moment.
  • Start tracking your spending. You will spend less, I guarantee it.
  • Sell things. I’m personally on an eBay kick right now. I’m totally going around my home and listing things I don’t need anymore. It won’t be much, but it’ll be more than nothing.
  • Ask for help. Don’t do this alone. Don’t be a hero. If you need money or food, look to food banks and community organizations. Start a GoFundMe. Post on NextDoor. Call your representative and ask what options are available. Now is not the time for pride.
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It’s that last point that I want to focus on. You are not in this alone. You may feel like it, but now is not the time to hole up and suffer in silence. No matter what your situation is, there are many, many people who are in the same situation you are, who have the same struggles as you. Some of these people have figured out ways to get by, and you can learn from them.

And even if they have nothing to teach you, you can still connect, reach out, be a part of a community of people struggling to get by. It will help.

Raiding your 401(k) is an option. But you have other options too. Your 67 year old version of yourself will thank you.

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