People Are Draining Their 401(k)s Before Retirement, and That’s a Big Mistake

It’s thousands of dollars, just sitting there with your name on it. But as tempting as it may be, your 401(k) should not be viewed as a piggy bank, available to fund everything from home renovations to tropical vacations and life’s little emergencies.

Yet, it seems that’s exactly what’s happening, and with alarming frequency.

Year to date, Americans have cashed out more than $57 billion in retirement savings early, according to the National Retirement Savings Cash Out Clock. And that number is increasing every minute of every day.

The bulk of those cash-outs are the result of people changing jobs — and, instead of rolling over their retirement funds into a new account, simply pulling the money out and paying whatever penalties they incur.

That can have detrimental consequences to their retirement security, say experts, who add that next to not contributing to an employer-sponsored retirement plan at all, cashing out is quite possibly the single most harmful action you can take if the ultimate goal is to achieve a financially secure retirement.

To be clear, we’re not talking about people tapping their 401(k)s because they’ve reached retirement — just those who are taking early distributions or withdrawing a portion of the money for purposes other than retirement. And there are many reasons why this is a bad idea.

The 10% Penalty

Let’s start with the most obvious drawback first. Taking an early distribution from a 401(k) plan — or an IRA, for that matter — almost always results in a 10% penalty right off the bat from the Internal Revenue Service.

As the IRS makes clear, withdrawing retirement funds before age 59 ½ generally results in an additional early distribution tax of 10%, on top of any other income taxes owed.

There are some exceptions, such as death or disability, and Roth IRAs offer additional flexibility. But in most cases, you’re going to immediately lose 10% — {poof!} — of any retirement funds you decide to take out early.

That’s a pretty steep surcharge to pay on money you worked hard to earn. And it’s just one of the penalties you’ll incur if you cash out early.

Increased Taxable Income

If the IRS lopping 10% off the top of your early distribution doesn’t discourage you from pulling money out of a retirement plan, here’s another substantial drawback to keep in mind: Retirement account withdrawals can dramatically increase your annual taxable income, explained Gage Kemsley, vice president of New Mexico-based Oxford Wealth Advisors.

“Distributions are added to whatever other income an individual earns, and because the U.S. tax rates are progressive, employees pulling from their retirement accounts early experience much higher tax brackets than they usually would,” explained Kemsley.

For example, the top tax rate for a married couple earning $75,000 in annual household income would be 12%. However, if they cashed out a $50,000 401(k) in the same year, almost all of that extra income would fall into the next bracket up ($77,401-$165,000), and thus be taxed at a higher 22% rate.

Lost Years of Compounding Interest

Undeniably, one of the biggest drawbacks associated with draining money from a retirement plan during the course of your life is the years and years of lost compound interest.

“Most significantly, the amount cashed out loses the potential for investment growth,” Sandy Blair, chairperson of the National Association of Government Defined Contribution Plan Administrators (NAGDCA) National Retirement Security Week committee and CalSTRS Director of Retirement Readiness.

Blair provided the following example to underscore her point:

A 35-year-old withdrawing $15,000 from an employer-sponsored retirement account, assuming a federal tax rate of 22% and a state tax rate of 5% (total of $4,050) and including the 10% withdrawal penalty ($1,500), ends up with about $9,450.

However, if that money went untouched and assuming a conservative annual return of 4% growth, that $15,000 left in the retirement account until age 65 would’ve grown 224%, to $49,702.

“Given the grim statistics for retirement security – one in three Americans have less than $5,000 saved, and 74% are unprepared for retirement — Americans can ill afford cashing out their retirement plan,” added Blair.

Better Alternatives

Many of these cash-outs happen when people change jobs. During a big transition like that, it’s easy to choose what sounds like the simplest option: cutting all ties and receiving a nice fat check in the mail.

But most 401(k)s allow you to either keep your money in the existing plan, roll it into your new employer’s 401(k), or roll it into an IRA, all of which are generally better long-term options.

If you do need a cash infusion, meanwhile, many employer-sponsored retirement plans allow participants to take a 401(k) loan instead of simply cashing out, which can be a somewhat better option.

Such loans involve essentially borrowing against yourself and paying the money back over time on a specific repayment schedule. The vast majority of employer-sponsored 401(k) programs allow them.

“You’re usually able to take the lesser of $50,000 or half of the account’s value and pay that over a five-year time frame at a fairly low interest rate of one or two points above the prime,” said Tom Lenkiewicz, senior wealth planning consultant with BMO Wealth Management.

The upshot of this approach is that the interest on the loan is money you’re paying to yourself, not to a bank, and it goes back into your retirement fund. Still, before doing this, it’s a good idea to compare the rates you might be able to get on other types of loans, such as a home equity loan or line of credit.

Yet another option, if you have a cash flow problem, is to adjust the withholdings from your paycheck, suggested Lenkiewicz. It’s a much simpler approach and one that may make sense if you typically receive a sizable tax refund each year.

One last, important consideration for those eyeing a retirement fund cash-out: There are a few instances when you can typically withdraw money from a 401(k) or IRA and avoid that nasty 10% IRS penalty. They usually cover such things as excessive healthcare expenses and first-time home purchases.

“You’re still going to pay income tax on it,” said Blair. “And I still wouldn’t encourage it. But if you absolutely have to do it, I would look at only doing it for one of those qualifying events.”

A Lifestyle Out of Control

Nearly all of the financial experts interviewed for this story noted that an individual’s need to withdraw money from a 401(k) to pay for living expenses is typically indicative of a larger problem. In other words, it may be time to take a long, hard look at your overall financial behavior.

The same lack of discipline that leads to tapping a 401(k) or an IRA as a piggy bank is often causing other problems as well.

“While this isn’t always the case, a premature distribution is usually followed by increased spending, increased debt and late payments,” said Kemsley. “Because retirement accounts are ‘up for grabs,’ other areas of financial discipline suffer as well. Many who take early distributions fail to properly account for taxes and are forced to take another distribution come tax time to cover the tax bill, which only compounds the issue.”

These same people will frequently turn to credit cards or short-term lending to cover expenses, and soon their finances have spiraled out of control, Kemsley added.

A far better alternative is to think of retirement funds like a locked fire extinguisher — break the glass only if facing a dire financial emergency. Otherwise, hands off, said Kemsley.

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Mia Taylor

Contributor for The Simple Dollar

Mia Taylor is an award-winning journalist with more than two decades of experience. She has worked for some of the nation’s best-known news organizations such as The Atlanta Journal-Constitution and the San Diego Union-Tribune. Taylor holds a graduate degree in Journalism and Media Studies and had a fellowship to study journalism at the San Diego affiliate of National Public Radio. Over the course of her career, she has won numerous journalism industry honors, including five awards from the North American Travel Journalists Association and the 2011 Walter Cronkite Award for Excellence in Journalism.