Debunking 401k Theory

Step Brothers

If you have a 401(k) retirement savings plan and you’re like the rest of working Americans, it’s highly likely that you don’t plan on touching that money until well, retirement. With social security increasingly becoming an unreliable source of income for many people, the younger generation is putting a lot of stock in their 401(k) savings.

Television gurus like Suze Orman and Jean Chatzky all preach the message that it’s a heinous crime to withdraw money early from your 401(k). But what if Suze Orman is wrong? Can it actually be smarter to cash in some of your retirement well before you will ever retire? If you have consumer debt, the answer is….yes!

How 401(k) plans work

Let’s quickly review how employer-sponsored 401(k) plans work. Employees are given the opportunity to elect to have a portion (usually no more than fifteen percent) of their pre-tax wages set aside in an investment account. In short, you get the benefit of saving money while deferring taxes.

Generally, the company will match part or all of the employee’s contribution to their 401(k), or offer a profit-sharing contribution to the plan. Because the nature of a 401(k) is that it’s an investment account, it can and usually will grow significantly over time. All 401(k) earnings (interest, capital gains, or dividends) are tax deferred, culminating in the blessed occasion when you turn 59 ½ and can withdraw funds without any penalties beyond regular income tax.

The good and the bad news

So why do all the gurus tell you not to withdraw early? It’s not because you can’t; it’s because the government imposes severe penalties to the tune of extremely high taxation whenever you withdraw early. Many 401(k) plans also allow withdrawals in the form of loans you eventually have to pay back with interest. Oftentimes, you can end up paying taxes twice over when you withdraw from your 401(k) early.

Is there really any good reason to withdraw early from your 401(k)? Absolutely, definitely, and yes. You will never hear the famous financial gurus tell you this, but sometimes waiting until you retire is quite simply too long. The number one reason to withdraw early from your 401(k) is to pay off debt.

Early withdrawal can save you money

For a person with thousands of dollars worth of personal loans that are growing at a very high interest rate, cashing out part of a 401(k) might be just the solution.

With interest rates on the rise, consumer loans and bad debt can quickly drain a person’s cash flow. Sure, early withdrawal from your 401(k) will get you tax penalties. But if the trade off is that you can move toward being debt-free and freeing up cash flow, tax penalties are a small price to pay for financial freedom

Consider the long term impact

It’s important to do long term cost analysis before choosing to withdraw early from your 401(k). If you’re in a situation where you’re only able to pay the minimum due on a high interest, high balance credit card, the long term consequences of not paying off that credit card can have a far greater impact on your finances than losing a few thousand dollars in taxes from your 401(k). For people who aren’t facing any type of hardship or significant debt burden, early withdrawal most likely isn’t the best solution.

Only you truly know your own financial circumstances. Do your own research and absorb as much knowledge as you can. Besides, it’s always possible that by the time you’re 59 ½ years old, you’ll be dead. I like to leave on a positive note so here’s a smiley face :)

Comments (8)

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  • I think those professionals are trying to prevent the majority of us from cashing in our 401Ks and buying that pretty red BMW that we keep flirting with…

    I have a buddy at work that is considering taking a loan from his 401K to help him refinance his house and avoid PMI insurance. I think in his case, with the mortgage interest rates so low… that it’s a great idea.

    So it depends :)

    • Yea it does. If I’m going to save more money and have less stress by taking the money out I’ll do it. But I won’t do it to buy a big diamond ring.

  • I would say (keeping an open mind, of course) that I’d take the loan over a withdrawal or cashout any day.
    A hardship withdrawal frequently comes with a rule that you can’t make new deposits for X months after.
    Consider this – you withdraw $10,000, and after penalty and tax, maybe clear $6500. But a deposit of $5000, would only cost you $3750 out of pocket, and after match, you have $5000 (50% of $10K) to borrow at today’s crazy low rates. Take the loan.

    • Good point. Sometimes a loan is the best tool for the job.

  • I write off the entire value of my 401K in my net worth. I DON’T count on it being there when I retire, and neither should anybody.

    If it is, great! If not, no biggie! Still max out every year everyone!

    • That’s a good thought. Kinda like what you should do with social security…the not expecting it to be there part.


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