4 Reasons to Rethink Cashing Out Your 401(k) or IRA Early
It's tempting to cash out your retirement savings in the midst of a short-term cash crunch. After all, you worked hard to save that money. And if you've had a recent job change, you likely know how much you have down to the penny. While the money may seem to beckon you to take it now, consider four important reasons to ignore that call.
Cashing Out is Common, But Costly
More and more people are dipping into their retirement accounts before they retire. According to recent research*, 34% of savers aged 35 to 54 have taken money out of an IRA or 401(k) before age 59½—the age you can make a withdrawal without a penalty.
For those under age 34, the likelihood is even higher, with 64% reporting that they've already taken some cash.
Why are people cashing out? Large purchases topped the list for the 35 to 54 group, but other reasons were named by savers of all ages:
But just because there are a number of reasons cited to cash out doesn't mean it's the best plan.
4 Reasons to Think Twice Before Cashing Out
1. The Tax Bill
Your retirement account grows tax-deferred until you withdraw. Taking the cash could mean a higher tax bill. The withdrawal amount is added to your normal income, potentially putting you in a higher tax bracket.
Depending on which bracket you're in, it could mean owing from 10-37% on your withdrawal. You could also owe state and local taxes on the amount. All of these will become a reality when it's time to file your taxes.
2. The Early Withdrawal Penalty for Cashing Out Your 401k or IRA
On top of your tax bill, the IRS imposes a 10% penalty if you are under age 59½. There are some exceptions, such as in the incident of a death or disability. However, the penalty is generally taken right off the top. Combined with your tax bill, you could forego nearly half of your savings.
Taxes + Penalty = Forfeiting Nearly Half of Your Money
This example assumes the following: A hypothetical 24% federal marginal income tax rate, a hypothetical 7% state income tax, and a standard 10% penalty for early withdrawal. This example is for illustrative purposes only. Please note that the 10% early withdrawal penalty does not apply to distributions made to an employee after separation from service during or after the year they turn age 55.
3. The Lost Opportunity
Taxes and penalties could hurt your nest egg today. But the biggest hit may be from missed growth opportunities for your financial future. Taking out money today can lead to missing out on your money potentially growing over the years.
Below is an example that shows the money you could potentially forfeit if $10,000 is withdrawn from a retirement account today versus keeping it invested for 25 years—or keeping it invested and adding to it. You can also run the cash out numbers yourself based on your own situation.
You withdrawal the money now and are under the age of 59½.
You keep the money invested for 20 years.
You keep the money invested and you add $100 a month for 25 years.
This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities. It assumes 6 percent returns for 25 years if money stays invested; and a withdraw with taxes and penalties. Cash out assumes a marginal federal tax rate of 22% and 5% in state taxes. Source: Time Value Calculator and Cash Out Calculator, Dinkytown, Inc., July 2021.
4. The Regret of Settling for Less
The last reason to rethink tapping into your retirement account is the potential sacrifices you may need to make in the future. Less money could mean working longer than you'd hope to or rethinking how you want to live. Even if you're able to adjust to a different lifestyle, you may not be able to eliminate regret from not saving more or the worry about whether you'll have enough money to last.
Regret and Worry are Real for Those Facing Retirement
Building a plan around your retirement savings can help you avoid the temptation to cash out early. A plan can help you realize how much you should save to cover a retirement that may last 20 years or more.
Not putting away more for retirement is many people’s biggest regret. Running the numbers to estimate how much you’ll need can help ease the temptation to take money out of your 401k or IRA accounts early.
Source: Study: 9th Annual survey of plan participants, American Century Investments 2021.
Already Took Cash from your 401(k) or IRA? You Have 60 Days to Put it Back
If you took money from a retirement account when you left a job, you can put that amount back into a qualified retirement account—such as an IRA or new employer's 401(k)—within 60 days. This is known as an indirect rollover and will save you from paying taxes on it or the early withdrawal penalty.
You can apply this rollover rule to an IRA, too, as long as you put the money back during the 60-day window. It's kind of like "borrowing" on a very short-term from your IRA, although there are strict IRS rules that could result in you losing your IRA's tax benefits. However, if you do redeposit the money in 60 days, you can avoid the taxes and penalties. Since the IRS considers this a rollover, you are only allowed one during a 12-month period.
Before considering taking money from a retirement account, consult a financial professional or tax advisor to understand the full implications to your taxes and your account.
Alternatives to Cashing Out Retirement Accounts
Needing to raise cash quickly doesn’t have to mean cashing out your 401k or IRA plans. Before you need money in a hurry, work to build an emergency fund of three to six months’ worth of expenses. Add up your regular expenses to figure out how much that means for you. To build up your emergency fund, start by looking to your budget to see what you can cut back or eliminate.
Need money and don’t have an emergency fund? Many 401k plans allow employees to borrow from their account balances, and then pay themselves back. Note you can’t borrow money from an IRA account.
Etrade Financial Q2 2021 Streetwise Report, April 2021.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
You could lose money by investing in a mutual fund, even if through your employer's plan or an IRA. An investment in a mutual fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.