Planning for retirement is an essential part of financial wellness. And while the retirement age has steadily increased over the years (major sigh), there are still ways to start planning for the future. After all, there’s gotta be more to life than working 40+ hour work weeks till’ we peace out. (Right, right?!) In order to secure a more comfortable and stress-free way to enjoy our golden years, it’s crucial to explore different investment options — and one popular choice is by signing up for a 401(k) plan, or employer-sponsored retirement account.
While 401(k) plans are generally viewed as wise investments, taking money out of a 401(k) account prematurely can result in penalties — and can even set you back in your retirement goals. “Do not touch the 401k,” as one Redditor aptly puts it.
But what exactly is a 401(k), and how does it work? We dove into the depths of these retirement accounts to understand how they work, how you can make contributions, and what the implications of early withdrawals are.
What Is a 401(k)?
A 401(k) is a retirement savings plan offered by many employers in the United States. It allows employees to set aside a portion of their pre-taxed salary towards retirement. In fact, the name “401(k)” comes from the section of the U.S. tax code that governs these plans. Think of it as a vessel designed to ferry your hard-earned money across the turbulent waters of time and inflation, so you can enjoy a smooth-sailing retirement.
How Do 401(k)s Work?
When you enroll in a 401(k) plan, you choose a percentage or a fixed amount to contribute from each paycheck. The funds are then automatically deducted before taxes are applied and deposited into a retirement account. Signing up for a 401(k) plan allows you to lower your taxable income, meaning you get to keep more money in your pocket right now. Generally, 401(k) contributions are a wise financial investment because they allow you to grow your savings using pre-taxed dollars. Contributions are made via:
- Employer Contributions: Some employers go the extra mile to make 401(k)s even sweeter by offering matching contributions, meaning they’ll add a percentage or a fixed amount to your account based on your contributions. Think of it as having a generous aunt or uncle who slips a little extra cash into your birthday card.
- Self-Contributions: Contributing to your 401(k) is as easy as setting up a direct deposit for your paycheck. Once you’ve enrolled, the designated amount will automatically find its way into your retirement account.
- The Power of Compound Interest: One of the most lucrative aspects of 401(k)s is the potential to harness compound interest to grow your savings. As your contributions grow over time, the earnings on your investments are reinvested in the form of interest, and the more your account grows, the larger the interest payments will be.
What Happens If You Need To Withdraw Funds From Your 401(k)?
While 401(k)s offer a tantalizing prospect of a well-deserved retirement, it’s important to remember that they’re designed for the long haul — and withdrawing money before reaching the age of 59 1/2 may result in penalties. The general rule is: If you withdraw money from your 401(k) before you turn 59 1/2, you’ll have to pay an additional 10% in income tax as a penalty. This is in addition to the regular income tax you’ll owe on the withdrawal.
Basically, Uncle Sam wants you to save those buckaroonies for when you truly need them, experts say. However, there are some exceptions — such as financial hardships or disability — that may allow penalty-free early withdrawals. These include:
- Hardship Withdrawals: If you experience a financial hardship such as a job loss, medical emergency, or natural disaster, you may be able to withdraw money from your 401(k) without paying a penalty.
- Qualifying Distributions: You may be able to take a penalty-free withdrawal if you’re age 55 or older and no longer working for the same employer with which you opened the 401(k) account with. Note that if you are laid off, fired, or need to switch jobs for whatever other reason, you are entitled to 30 days (by law) to figure out what you want to do with your 401(k) account.
- Roth 401(k)s: There is no early withdrawal penalty for qualified withdrawals from a Roth 401(k) because these contributions are deducted from after-tax income, and there are no tax deductions in the year of contribution.
Other Things To Keep in Mind
It’s important to note that even if you’re eligible for an exception to the early-withdrawal penalty, you may still owe income tax on the withdrawal. If you’re considering withdrawing money from your 401(k) before the age of 59 1/2, it’s important to weigh the potential penalties and benefits carefully. If you need the money for a legitimate hardship, then an early withdrawal may be the best option for you. However, if you’re just looking to get your hands on some extra cash, you may want to consider other options, such as a personal loan or a credit card.
Here are some additional things to keep in mind when considering an early withdrawal from your 401(k):
- You’ll Reduce Your Retirement Savings: Every dollar you withdraw from your 401(k) is a dollar that’s no longer growing tax-deferred towards your retirement. This can have a significant impact on your retirement savings over time.
- You May Have To Pay State Income Taxes: In addition to federal income tax, you may also have to pay state income tax on an early withdrawal from your 401(k) depending on the state you file taxes in.
- You May Lose Out on Employer-Matching Contributions: If your employer offers a matching contribution, you’ll lose out on any matching contributions that would have been made for the year in which you take the withdrawal.
If You Can, Leave It Alone
According to many users on the r/povertyfinance subreddit, taking money out of a 401(k) early can be an expensive mistake. “Pulled my pretty sizable 401k out a few years ago because I felt desperate,” writes one Redditor, noting that the decision was the “worst mistake” of their lives. “I’m back in the same boat of paycheck to paycheck.”
“Pulling money out of 401k to clean up other aspects of your financials is generally considered to be pretty stupid unless it is a last resort like preventing the house from getting foreclosed on,” writes another Redditor, adding, “Not only do you get hit with the taxes and capital gains when you pull money out of 401k, but also the early withdrawal penalties.”
“This can easily wipe out 30% or more of the money and it kills the long term growth or your retirement accounts. It also doesn’t force you to fix your underlying bad habits that got you in the shifty situation in the first place,” the user adds, before ending on a harsh, but clever note: “Bottom line, your 401k doesn’t exist, don’t touch it.”
The Bottom Line
Indeed, one of the best ways to look at a 401(k) is to label it as an emergency fund that you shouldn’t touch unless absolutely necessary. By resisting the temptation of early withdrawals, you can avoid penalties and let the magic of compound interest work its wonders. Go on and sign up for a 401(k), bestie. Your future self will thank you for it.
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