Why You Shouldn't Withdraw from Your 401(k)

If you take money out of a 401(k) account, the government will be on you like white on rice. That’s because you invested in your plan before taxes were assessed on your money. Naturally, the IRS and your state’s department of revenue want what you owe them. The federal government wants its part fast: It immediately takes 20% of the amount you withdraw.

That’s only the start of the government’s grab. You pay an additional 10% penalty when the next income-tax deadline rolls around. And you could owe even more taxes depending on your income-tax bracket. Say you fall in the 28% tax bracket. The government only got 20% of your withdrawal amount when you took the money out. It gets another 8% come tax time. You have to pay state income taxes on the amount you withdraw, too.

As a result, you don’t receive the whole amount of your savings, not by a long shot. You’ll usually fork over at least 30% of your money to the government.

That leads to the final problem with 401(k) withdrawals. You end up with less money working for you in your retirement account. That can mean forsaking big bucks down the road. Read "What Compounding Can Do for You" for the specifics.

Here’s the essential question you need to ask: Is the money today worth more to you than a considerably bigger sum in the future? Let’s say you want to take $50,000 out of your 401(k) account. You’d receive no more than $35,000 after the taxes and penalties are assessed. But if you leave the $50,000 alone and your investments return 10%, on average, per year, you’d have $541,500 after 25 years. That’s a good-sized nest egg.

What about a Loan?
You might ask, "What if I take out a loan from my 401(k)?" As ideas go, this is better than a 401(k) withdrawal. You won’t owe taxes on the loan, as long as it amounts to less than 50% of your 401(k) balance or $50,000, whichever figure is smaller. The interest you pay on the loan, usually around the current prime rate, goes back into your retirement account, too.

The drawbacks are multiple, however. You have to pay back the loan, of course. That’s money that could have gone into your retirement kitty, where it would have compounded. (This article at the 401Kafe explains the consequences.) There are also tax problems with 401(k) loans, because you pay the interest back with aftertax dollars and you have to pay income taxes on the same money when you withdraw it.

Another issue directly affects Carrie. You can’t take out loans on 401(k) accounts after you have left the company. So Carrie’s plan won’t work. In fact, if you take out a loan and then leave your job, you might have to pay back the entire loan at once. That depends on your employer’s policies.

The bottom line: It’s difficult to use 401(k) savings for anything other than retirement.

Hap Bryant contributed to this article.