Dear Rich Lifer,
Imagine you’re offered two choices:
Get $100 today or $110 tomorrow.
Statistically speaking, most people would choose to take the $100 today.
But, if you reframe this scenario and offer someone $100 in one year and $110 in one year and one day from now, the majority of people will wait the extra day for the $10.
This makes absolutely no sense.
Why do most people choose a bigger reward when the wait is longer versus a smaller reward when the wait is shorter?
The answer has to do with a cognitive bias behavioral economists call hyperbolic discounting.
Hyperbolic discounting essentially states that people tend to choose smaller-sooner rewards over larger-later rewards as the delay occurs sooner rather than later in time.
Or, put another way, we prefer immediate rewards in the short term. But, we’re more patient and wait for better rewards in the long term.
Then why is saving for retirement so hard?
The reason people struggle with saving for the long term is because most day-to-day decisions are competing with immediate rewards in the short term.
Do you go out for dinner tonight, or save that $50 so it will grow to 4x that amount when you retire?
The reason I bring this up is to show you what your brain is doing when you start to think about taking money out of your 401(k) early.
According to Fidelity, 1 in 3 investors have cashed out of their 401(k) before reaching age 59 and a half, often when changing jobs.
Most people considering cashing out early are doing so because of short term needs.
Maybe your car breaks down and you need an extra $10,000. Maybe you lose your job and you need to pay your mortgage.
Whatever the situation may be, taking money out of your 401(k) probably seems like your only option.
What Happens When You Withdraw Early?
Three things happen when you take money out of your 401(k) before you turn 59 and a half:
1) The IRS Takes 20%
The IRS usually requires automatic withholding of 20% of a 401(k) early withdrawal for taxes. So if you withdraw $10,000 in your 401(k) at age 50, you may only get back $8,000.
2) The IRS Will Penalize You 10%
If you withdraw money from your 401(k) before age 59 and a half, the IRS will hit you with a 10% penalty when you file your tax return.
3) It Could Mean a LOT Less Money Later
If you’re pulling money out when the market is down, you’re killing your chances of a rebound. It’s also erasing all the hard work and saving you did up until this point.
That’s why withdrawing early from a 401(k) is not an option in my opinion.
There are other ways to meet your short term financial needs without sacrificing your retirement nest egg…or at least not giving so much of it away to the government.
Rather than lose a portion of your investment account forever, some 401(k) plans offer loans that allow you to replace the money through payments deducted from your paycheck.
You’ll have to check with your plan provider and see if you’re eligible but a 401(k) loan is better than taking a withdrawal and incurring those aforementioned penalties.
Exceptions to the 10% Penalty
If you’re really stuck and it seems like tapping your 401(k) is the only option, before you do make sure you check to see if you qualify for any exceptions to the 10% early distribution penalty.
If your situation falls under the following conditions you are exempt from the 10% penalty:
- You leave your job and are at least 55 years old
- You have to divide your 401(k) in a divorce
- You withdraw an amount less than is allowable as a medical expense deduction
- You rolled the account over to another retirement plan (within a certain time).
- You begin substantially equal periodic payments
- The money paid an IRS levy
- You overcontributed or were auto-enrolled in a 401(k) and want out (time limits apply).
- Your withdrawal is related to a qualified domestic relations order
- You die, and the account is paid to your beneficiary
- You become disabled
Other exceptions to the 10% penalty are hardship distributions. In order to qualify, the IRS needs to decide whether “an immediate and heavy financial need,” is merited. This includes:
- Medical bills for you, your spouse or dependents
- Money to buy a house (if you’re a first time home buyer)
- College tuition, fees, and room and board for you, your spouse or your dependents
- Money to avoid foreclosure or eviction
- Funeral expenses
- Certain costs to repair damage to your home
Your employer’s plan administrator should be able to determine whether you qualify for a hardship distribution or not, and you’ll definitely need to explain why you can’t get the money elsewhere.
Withdrawals in all of these scenarios would only be subject to ordinary income taxes and not the additional 10% penalty.
But you have to make the withdrawal according to your 401(k) plan rules and have appropriate documentation.
The reason why early withdrawals can be so devastating is because you lose the potential future investment growth of that retirement money. 401(k) plans have annual contribution limits, so you can’t make up for a previous withdrawal later.
“Catching up” is almost impossible.
This is why it’s so important to consider the implications of your decision fully. Remember that your brain is wired to choose short term gratification over long term gain.
Do your best to override this thinking and make sure you protect your future self.
To a richer life,