We are often asked by our clients about taking money out of their retirement accounts early, be it a 401(k), 403(b), or one of the IRA iterations. In the section below, we respond to some of the most common questions we get related to this topic.
What are the potential long-term consequences of cashing out on my retirement plan early?
Aside from the immediate tax consequences and early withdrawal penalties from the IRS, investors are losing out on future growth opportunities when they pull out of retirement accounts early. If you cash out early, you are missing out one of the biggest advantages of a pre-tax retirement plan – tax deferred growth. The compounding of returns over time is a powerful force, and pulling early can dramatically weaken this effect, even if it’s just a few years early.
What are some alternative options to cashing out on my retirement plan?
Taking funds early from a retirement account should be near the bottom of the list if you run into a near term need for cash, and investors should carefully consider other options before doing so. If you have other more liquid investments, like those in a brokerage account, you should consider using those first. Unlike in a retirement account, these types of investments will generally only be taxed at the capital gains rate and will avoid being taxed fully as income like a retirement account. You also won’t incur an IRS early withdrawal penalty if you liquidate these types of accounts.
Also, most employer sponsored retirement accounts offer a loan privilege. Although not without risks, taking a loan from your employers retirement account, like in a 401(k) or a 403(b), can help you avoid the costly penalties and taxes of an early distribution.
Additionally, you can take your contributions from a ROTH IRA at any time, without taxes or penalties. Although you’ll be harvesting from your future self, in a pinch, this can be more advantageous than paying early distribution penalties and taxes. This rule, however, does not apply towards employer sponsored ROTH accounts, like a ROTH 401(k) or a ROTH 403(b).
How can I determine if taking out a loan from my 401(k) is a better option than cashing out?
Taking a loan from your 401(k) will give you access to your retirement account funds quickly, and without incurring early distribution penalties. It will also allow you to pay yourself back over time, which will help you pick back up where you left off with your retirement savings.
However, there are several cons to consider. First, most plans will assess an annual interest charge on the loan. These charges can take a big chunk out of your retirement. Second, when you’ve borrowed from your 401(k), these funds are no-longer in your account working for you. This could mean passing up on significant growth if the loan is taken during a run-up in the market. Lastly, if a 401(k) loan goes into default, the IRS will consider it an early distribution, and will tax it fully as income and asses the early withdrawal penalty of 10%.
What are the tax implications of cashing out on my retirement plan?
Cashing out early has a number of disadvantages from a tax standpoint. Most importantly, participants will be taxed fully based on the current year’s income tax bracket. If you believe your effective income tax will be lower in retirement than it is today, an early distribution will come with a higher tax bill. Additionally, many pre-retirees plan on relocating to a state with no or low state income tax once they retire. If the early distribution is taken while a resident of the state with higher taxes, they’ll be on the hook for a state income tax they might otherwise not have paid. Cashing out early will also incur the IRS’s early withdrawal penalty of 10%.
What steps can I take to ensure that I am maximizing my retirement savings?
In general, time is the most important factor to maximizing retirement savings. The earlier someone can start saving, the better, as the powerful effects of compounding interest have longer to work. Investors should also try to take full advantage of the tax advantaged accounts that are available to them. This can mean funding retirement accounts at work, and on their own. Savers should also keep an eye on plan limits, as these are increased in most years and allow for more tax-advantaged savings. The underlying investment portfolio of the retirement account matters too. We often have new clients come to us with portfolios that didn’t align with their tolerance for risk and underperformed for many years, and you just can’t get that time back.
