With the economy in recession, we are sometimes asked whether it makes sense to take an early 401(k) withdrawal. The answer is “no.”
Thank you for reading this week’s column.
OK, we’ll elaborate. When it comes to taking an early 401(k) withdrawal, meaning withdrawing funds before the age of 59.5 and incurring a 10% penalty on top of applicable taxes, there are bad reasons to do it, and worse reasons.
Reason No. 1: You are worried about the markets
Of all the reasons to withdraw from your 401(k) early, this is probably the worst. While the markets will likely go down at some point, trying to guess by how much and when is a fool’s errand.
Here’s what we do know. Historically, the markets grow over time. If you invested heavily before the stock market crash of 2008, the worst possible time over the last few decades, you still likely made money.
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The truth is, if you are under 59.5 years old, you are likely far enough away from retirement that temporary setbacks won’t impact you that much. A 10% penalty on your entire withdrawal? Paying income taxes on a lump sum during your prime earning years? That will impact you.
And remember, you have been putting money in your 401(k) all this time because you will need it when you retire. If you take the money out now, it will not grow, and it will not be there when you retire.
Reason No. 2: You want to buy a house
This one is a little more reasonable. There is no disputing the potential advantages of buying over renting in the long-term. Interest rates are near historical lows. And there are provisions to withdraw for home purchases without penalty.
The problem is that you are still missing out on the opportunity to let your money grow, tax deferred. You are still paying taxes on the money at a likely higher rate than you would be in retirement. You are still setting back your other long-term financial goals.
Of course, there are certain situations where it might make sense. Say, for example, you want to purchase a relative’s house to keep it in your family, or you need a mother-in-law apartment. In those cases, consider taking from an IRA, which has provisions for first-time homebuyers.
Reason No. 3: You lost your job due to COVID-19
This one is a bit trickier. Obviously, it does no good to have money available for retirement if you cannot support yourself or your family now. In this case, early withdrawal should be a last resort, after the emergency savings are depleted and after alternative avenues for generating income have been explored.
Per recent legislation, you can withdraw up to $100,000 without penalty, and spread the taxes due evenly across 2020, 2021 and 2022. If you pay back the amount within three years, you can get a refund on the income taxes owed. If this is the route you choose, we recommend making that repayment a priority.
The truth is, there are almost always better options for keeping your finances on track. Work with your financial adviser, who can look at your specific short-term needs, and find a way to meet them without sacrificing your long-term goals.
