Why Cashing Out Your 401(k) Early Is a Bad Idea
Audio version available here (1 min. 40 sec.)
There are many reasons why a person may decide to drain their 401(k). They might have just quit their job, are preparing for new life circumstances, or have a dire financial need. But whichever the circumstances, making this move can be a financial disaster for you.
Typically, when a person has an employer-sponsored 401(k) and they switch jobs, they tend to either leave the account where it is or roll it over with their new employer. But about 33% of more than 1,500 retirement accounts analyzed by Vanguard Investments were cashed out. There are several pitfalls to this practice.
The first is that you could end up paying thousands of dollars in extra taxes. The higher your 401(k) cash out, the more taxes you will pay, especially if you have to pay federal, state, and local taxes. Combined, all these taxes can diminish your payout by about a third of its original value. If you drained your 401(k) due to financial distress, the sacrifice may not have been worth it.
In addition to income taxes depleting your cash out, the penalty for early withdrawal will be a further hit. Unless you are 59 ½ years or older, or you qualify for an exception, you will have to pay an additional 10% tax as a penalty for an early distribution. If you are withdrawing more than $10,000, that’s at least $1,000 in penalties you’ll have to pay.
Even worse, quitting your 401(k) will be detrimental to your long-term financial growth. Without a tax-deferred retirement account, it will be incredibly difficult for you to build substantial savings for when you retire. This is also the case if you switch jobs often and are not careful in reviewing the terms of your new employer’s retirement contribution policy. If you are not at least matching your previous contribution amount, then you are losing out on growth opportunities.
These reasons are great motivation to not abandon your 401(k). If you still feel the need to cash out your retirement account well before you actually retire, then we highly recommend you first meet with a tax professional who can guide you on how to do it without wasting money. For the right guidance, reach out to XQ CPA’s tax experts today. We are here to help you.
Phone: 832-295-3353
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Want to pay less taxes? Read XQ CPA's official tax planning guidebook! How to Grow Your Wealth Through Tax Planning.
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