Why a 401k Withdrawal is BAD...
Except for ONE time

401k withdrawal Photo courtesy of EngineeringDaily.net

A 401k withdrawal shouldn't be the last resort. Experts will tell you that it should be the option after the LAST resort. That's putting it lightly.

You must know the 401k withdrawal rules because they may affect your investment if you choose to pull your money out early.

Rules of the Game

Regardless of when you withdraw from your 401k retirement plan, the distributed money will be taxed as ordinary income. You have deferred taxes for so long in this tax deferred investment and now Uncle Sam gets his cut.

However, if you are withdrawing before you reach the ripe age of 59 ½, you will incur an additional 10% penalty tax for your 401k early withdrawal. What happened to all of the tax saving tips you received from the experts? Uncle Sam's cut just got bigger.

Some exceptions to this penalty tax rule include:

  • You die. Payment is made to your beneficiary.
  • You become disabled. You access funds because if you have a qualifying disability. Do you wonder what qualifies?
  • Equal Payments.You begin substantially equal periodic payments. (The payments must continue for at least 5 years or until the employee reaches age 59½, whichever is the longer period.)
  • Quit in time. You access funds after you terminate employment during or after the calendar year in which you reach age 55.
  • Pay up for divorce. You distribute funds to a payee under a qualified domestic relations order (QDRO). This is common for a divorce.
  • Medical bills. You withdraw an amount less than is allowable as a medical expense deduction.

You can read about these exceptions and more 401k withdrawal rules here on the government website.

Lost Opportunity

If you have read our other articles, you know that we are no friend to opportunity cost. A 401k withdrawal dances with this devil.

When you withdraw your money from your plan, you lose the opportunity, an eroding factor of money, of any future investment growth. And, since there are annual contribution limits on your account, you cannot make up for a withdrawal later.

This may be an issue for you if you are approaching retirement and you find that you need to bounce back from taking a loss on your retirement plan.

Yet, another reason why a 401k withdrawal is such a bad idea.

Alternatives?

401k Loan

Most financial pundits will suggest you take a 401k loan. However, you still have to deal with the downsides of this option too.

Things like:

  • Limitation on how much you can borrow.
  • Incurring a lost opportunity cost.
  • A 5 year loan period or the loan is due if your job is terminated.

Waiting - With Penalties

On the flip side, the gurus will tell you to delay receiving distributions until April 1 of the year following the year in which you reach 70 ½ - typical 401k advice.

However, the issue you may experience here is that you must withdraw at least your Required Minimum Distribution (RMD) annually. Many retirees today are are trying to recapture their losses due to market downturns.

But there is a penalty if you don't withdraw the RMD annually. The penalty is 50% of the difference between what should have been distributed and what was actually withdrawn.

Lack of Control

So what have you learned about this so-called asset thus far?

If you withdraw the funds too soon, you get penalized!
If you withdraw the funds too late, you get penalized!
If you don't play by the rules, you get penalized!

I thought the 401k retirement plan was supposed to be the best investment?

So, When a Withdrawal is Perfect

Despite my harshness towards this financial move, there is one time when a 401k withdrawal makes perfect sense:

When you never intend to invest in a 401k EVER again.

Once I learned about 401k retirement plans and all its disadvantages, I decided to stop contributing to my employer's plan and closed that chapter in my financial life.

I decided to never invest in a 401k plan ever again.

Yes, I withdrew all the cash.
Yes, I incurred the 10% 401k early withdrawal penalty.
Yes, I never looked back.

If you have come to the point where you want to make this decision, go for it. This decision alone has been one of the defining moments in our journey to achieve financial freedom.

We stopped following the crowd because frankly, most of the crowd is lost.

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