How Early Withdrawals Can Tax Your Retirement Savings

If you can't replace the money, an early 401(k) withdrawal will make you worse off in retirement.

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By Emily Brandon

Taking money out of your 401(k) before age 59½ typically results in taxes and penalties on the amount withdrawn. Investors who take early withdrawals also miss out on the tax-deferred growth their savings would have accumulated if they had left the money in the 401(k) plan or rolled it over to an individual retirement account. Here's what happens when you take an early 401(k) withdrawal and how to limit the fallout.

Income tax. Regular income tax is due on each withdrawal from your traditional 401(k) plan. A worker in the 25 percent tax bracket who withdraws $10,000 from a 401(k) plan will owe $2,500 in federal income taxes on it, and perhaps more in state income taxes. When you receive a 401(k) distribution, 20 percent will typically be withheld for income tax purposes. So, when you withdraw $10,000 from a 401(k) account, you will actually only receive $8,000. You will need to come up with any additional tax you owe from the distribution itself or another source. "Many people who have cash-outs when they leave a job often are not leaving their job voluntarily, and some of this is being used as a temporary stopgap measure," says Jack VanDerhei, research director of the Employee Benefit Research Institute. "If you have a situation where you don't absolutely have to have the money, you should keep as much in the tax-advantaged accounts as possible."

You can avoid paying income tax on your 401(k) balance when you change jobs by leaving it in the 401(k) plan, rolling it over to an IRA or depositing the money in your new employer's 401(k) plan. If you've already taken a cash distribution, you can still avoid paying tax on it if you put the entire amount, including the withheld 20 percent, into another tax-deferred account within 60 days. A 401(k) loan can also give you access to your retirement stash without paying income tax on it, but you have to pay it back with interest, and if you leave the job, the loan typically becomes due. If you can't pay it back, the loan balance can become an early taxable distribution. "In virtually every case I can think of, I'd rather go with the loan," VanDerhei says. "You have flexibility, you have the ability to put the money back in the account on a tax-advantaged basis and you can most likely avoid being taxed on it."

Early withdrawal penalty. If you are under age 59½ when you take a 401(k) distribution, you must pay a 10 percent early withdrawal penalty in addition to income tax on the amount withdrawn. A 50-year-old in the 25 percent tax bracket who withdraws $10,000 from his 401(k) will forfeit over a third of the withdrawal, including $2,500 in federal income tax and $1,000 for the early withdrawal penalty. However, there are several exceptions to the early withdrawal penalty. If you lose or leave your job at age 55 or later (or age 50 for public safety employees), you can take distributions from the 401(k) associated with that job without penalty. You can also avoid the early withdrawal penalty if you are totally and permanently disabled, have medical expenses that exceed 10 percent (or 7.5 percent for those born before Jan. 2, 1949) of your adjusted gross income or are a member of the military reserve and take the distribution during a period of active duty that exceeds 179 days. Another strategy to avoid the penalty is to set up a series of substantially equal periodic payments at least annually over your life expectancy using a distribution method approved by the Internal Revenue Service.

Lost investment growth. An even bigger cost to early 401(k) distributions is the investment gains you would have gotten if you simply left the money in the account to grow. If you have $10,000 in a 401(k) account at age 30 and leave it there without any additional contributions, it will grow to $106,766 by age 65, assuming 7 percent annual returns. If you instead withdraw that money at age 30 and are in the 25 percent tax bracket, you will only get $6,500 after paying income tax and the early withdrawal penalty. "If you're young, time will do some heavy lifting for you," says Therese Govern, a certified financial planner for Therese Govern Financial Advisors in Seattle. "You want to keep it in that tax-deferred wrapper until retirement." Outside of a retirement account, your savings will compound more slowly because you may need to pay taxes on the gains each year.

Less money in retirement. Many workers dip into their 401(k) plans early as a result of job loss or another financial setback. "When families experience financial shortfalls, their 401(k) accounts are often the only financial safety net they have," says Marianne Cooper, a Stanford University research associate and author of "Cut Adrift: Families in Insecure Times." "In hard times, families rely on these accounts so they can keep paying the bills." But while an early 401(k) withdrawal may solve the immediate problem, it can create other financial complications later on.

Early 401(k) withdrawals can necessitate delaying retirement or lowering your retirement standard of living if you don't take steps to get your retirement finances back on track. "While a necessary stopgap measure, withdrawing money from their retirement accounts puts families at risk in the future," Cooper says. "Since few families can pay back what they withdrew, many will have a significantly smaller nest egg to live on later in life. A lot of people will never have enough to be able to retire."

Emily Brandon is the senior editor for Retirement at U.S. News. You can contact her on Twitter @aiming2retire, circle her on Google Plus or email her at

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And when you turn 70 and 1/2, you are required to start taking out a percentage of your IRA or face a 50% penalty on what your were supposed to withdraw. Sam doesn't want to wait to long for his money. It's damned if you do and damned if you don't.

July 22 2014 at 8:40 PM Report abuse +2 rate up rate down Reply

Was that Barack H. Obama twittering or just a Chuck U. Farley diatribe?

July 22 2014 at 7:39 PM Report abuse -2 rate up rate down Reply
Charlie Jackson

We need some new blood, new concepts, and new investors and new entrepreneurs. Do we have skills necessary to compete in the new era of manufacturing? isolationism only pushes us back into 18th century---I rather see concepts and fresh ideas.

Competition is what counts -- we must create and instill new concepts in our educational system that enables us to compete with rest of the world for the next 100 years and beyond.

Of course people who lag in education and skills will continue to oppose us. ----Let us empower our own people leading the charge !!

July 22 2014 at 6:53 PM Report abuse +3 rate up rate down Reply
Charlie Jackson

Still -- my question is --- what you consider early withdrawal is not coinciding with my concept of retirement. Stop telling me when to retire and when not to----Stop bullying over my retirement money. STAY AWAY and STOP BULLYING ME!!

July 22 2014 at 5:59 PM Report abuse +1 rate up rate down Reply
Charlie Jackson

I believe in investing and supply and demand --- It is a great concept when there no manipulations, monopolies and when every business is transparent. When the consumers are suppressed then that is end of the end of the free market concept.

July 22 2014 at 5:56 PM Report abuse +2 rate up rate down Reply
Charlie Jackson

I think people should be able to retire whenever they want or able to rejoin the workforce when they chose to!!??

July 22 2014 at 5:43 PM Report abuse +2 rate up rate down Reply
Charlie Jackson

Our House Members have become Wall Street6 Parrots. Please defeat these house members who are Anti America and Americans

July 22 2014 at 5:40 PM Report abuse +2 rate up rate down Reply
1 reply to Charlie Jackson's comment

Do you mean all the Democrats? You did say anti-Americans.

July 23 2014 at 9:50 AM Report abuse rate up rate down Reply
Charlie Jackson

Wall Street wants hold on to your 401K and Retirement monies as long as possible --- What is Early Withdrawals? and Who made that decision? First of all who are you to tell us when to retire and when to withdraw our own money? Get the F--- out of our lives

July 22 2014 at 5:38 PM Report abuse +2 rate up rate down Reply
Charlie Jackson

It's no longer supply and demand ---- it's just being manipulated and hijacked with the blessings from House Leaders and Corrupt Supreme Court Judges

July 22 2014 at 5:26 PM Report abuse +3 rate up rate down Reply
Charlie Jackson

Our house leaders, Corrupt Supreme Court Judges and Wall Street Crooks are on the same page ----in Looting of the Americans and America

July 22 2014 at 5:17 PM Report abuse +4 rate up rate down Reply