Early withdrawals from a 401(k) can be costly

If you’re considering taking a 401(k) withdrawal before you’ve reached 59 ½ years old, I would think twice.  In most cases (excluding those where you’ve left your employer in/after the year you turned 55), taking a 401(K) withdrawal before you reach 59 ½ will cost you.

Let’s walk through a simple example:

Sample Facts:

• 40 year old taxpayer
• $100,000 401(k) balance that is being entirely distributed
• Distribution does not meet one of the IRS exclusions for escaping the 10% early withdrawal penalty.
• Taxpayer’s marginal Federal tax bracket is 25%
  • For this example we’ll exclude state income tax

401(k) distribution taxable income                         $100,000

Less:  Fed income tax on distribution (25%)        ($25,000)

Less:  Early Withdrawal Penalty (10%)                    ($10,000)

Net after tax                                                                         $65,000

Now, let’s stop and think for a second.  A $100,000 distribution costs the taxpayer $35,000.  Another way to put it is to say the taxpayer paid a 35% interest rate (obviously much more if you annualized the rate).  I bring up the interest concept because an alternative to a complete distribution of your 401(k) is borrowing from (taking a loan against) your 401(k) account.   A second option would be tapping into the equity in your home or other assets you could borrow against.  I really would use the complete distribution of a 401(k) (assuming early withdrawal) as a last resort.

The tax code does allow taxpayers to take early withdrawals from a 401(k) that are NOT subject to the 10% penalty (https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions).  These distributions are still taxable for income tax purposes.  Given the example above, you’d still be paying 25%.

Here’s another thought, numbers aside.  Many people go through the process of distribution funds (early) from a 401(k), consulting with their 401(k) custodian, and withholding Federal income tax from the distribution and still end up with a tax bill.  Why?  Because they underestimate the tax burden (early withdrawal penalty) and/or the distribution puts them in a higher tax bracket because of the additional income.  Maybe the top tax bracket they normally reach is 25%, but this additional income puts them in the 28% or 33% bracket?  You can see how this can cause an unanticipated tax burden.

Again, there may be financial situations that simply demand you take an early withdrawal from your 401(k), but I would strongly suggest that you educate yourself on the potential costs so you are not surprised when you file your tax returns.