Consequences of Taking Money From Your 401k

by Scott Sery on March 19, 2013

401kAs we begin our working careers, retirement seems like a distant concept; and rightly so, for many it is 30 to 40 years away.  Because it is so far away, many people starting out do not even bother to enroll in the 401k available through work.  Those who do enroll will fall into two basic camps.  Some will set it up and forget about it and not worry about it until they are approaching retirement.  And some will watch it closely, seeing how much they have.  Unfortunately, it is the latter camp that often will dip into their retirement savings for purchases that are not quite necessities.

I am not saying there are not times when it is acceptable, or even necessary, to raid your 401k.  But these times should rarely, if ever, come up.  For instance, large unforeseen medical bills may require a person to have access to extra cash.  If you are disabled and no longer able to work you may need to take what is the equivalent of an early retirement.  You can even get at your retirement savings if you are buying a house for the first time.  The thing these all have in common is that you can get around the 10% tax penalty imposed by the IRS.

There are other times that may seem like an emergency where a person can be tempted to use their 401k.  But even if your car is broken and you desperately need a new one, this is not an emergency.  Nor is taking a vacation.  Or a flat screen TV.  There are very few times where purchasing any sort of goods would constitute an emergency.

The reason is that there are bigger consequences than what you can immediately see.  Take this example.  You are 30 years old making $50,000 per year and putting 10% of your income into your 401k.  By the time you are 65 you will have just over $965,000 (assuming 8% average rate of return and no company match).  While this should be enough to ensure a comfortable retirement, it often does not turn out this way.  Suppose instead you work at that job for 8 years and decide to accept an offer with another company.  You cash in your 401k that has now grown to $56,000.  You buy a truck and take the family to Hawaii.  Starting the new job, which pays $60,000 per year, you invest in the same way.  When you hit 65 you will have a little over $575,000.  That new truck and vacation cost you almost $400,000.

Now this is a highly unscientific analysis that does not take into account inflation or getting raises.  But the fact remains that nearly half of those switching jobs will cash out their 401k rather than roll it over.  Instead of setting yourself back nearly half a million dollars, there are better options.  The best one is to borrow from your 401k.  Most plans will offer this provision, and instead of sucking the money out, the account will be the collateral.  So the investments can continue to grow, and you can have access to your money.  For emergencies of course.  The downside is that some plans do not allow for loans, and most will only allow a maximum of 50% of the account value or $50,000 to be taken in loans (whichever is less).

The 401k is a retirement savings vehicle.  It is not short-term money to use as you please.  Instead of cashing out your 401k, and paying between 25% and 50% in taxes and penalties, use it as it was intended.  For those emergencies and opportunities, you should have a well funded opportunity and emergency fund.  If you leave the 401k alone (and are setting aside enough of your check) you can retire a millionaire.

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Scott Sery

Scott Sery is a native to Billings, Montana. Within an hour in nearly any direction he can be found fishing, hunting, backpacking, caving, and rock or ice climbing. With an extensive knowledge of the finance and insurance world, Scott loves to write personal finance articles. When not talking money, he enjoys passing on his knowledge of the back country, or how to live sustainably. You can learn more about Scott on his website Sery Content Development

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