Why early 401k withdrawals rarely make sense
Last week a reader asked if closing his 401k made sense in light of the sharply declining stock prices. The short answer is no, but a commenter wondered if this was always true.
Playing a little Devil’s Advocate–and someone asked me about this–why do we have to stick it out? What if the cost of pulling it out of your 401k and putting it in another idea (while continuing to reap the benefits of buying low and still contribute, but take out your principal)? True, you may not have known that hindsight would be 20/20, but an interesting idea to think about…
I’m not moving personally, but something to think about still. Good post! -Hank from Mib
When we look at the numbers, it becomes clear that it would be very difficult to overcome the tax penalties tied to early withdrawals.
To review,
- 100k after 41% stock market drop = 59k
- 59k after 10% early withdrawal penalty and 25% tax bracket = $38,350
The first $41,000 lost is unavoidable, due to a downturn in the market. But the next $20,650 lost would be self inflicted.
In order to recoup the $20,650 lost to taxes, you’d need to earn a 53.8% one-year return on your remaining $38,350 or a 9% return—five years in a row.
Of course, these returns ignore the impact of taxes. You would need to earn an even higher annual return or invest even longer to make up for taxes.
In order to earn a 9% return, you would probably have to invest in the stock market again or get involved in a business venture which would involve a fair amount of risk and time.
And if this was even possible, then why wouldn’t one take this route before the stock market had a bad year? (The S&P 500 finished last week down 40.6% for the year.)
If you can’t stomach further stock market exposure, or if you have a lot of debt, a better strategy would be to stop future contributions and redirect that money to paying down debt or into safer investments.
Just resist withdrawing that money early—the penalty is simply too severe for most investors to recover from.
