A lot of times, people take premature withdrawals from 401k’s or other qualified retirement plans when life throws them a curve ball and they need money to rectify a situation.
While this may seem like a good way to meet a current need, most people don’t fully understand the effect it will have on their future, especially retirement.
Let’s take a 35 year old, Mike, who is single and makes around $100K of taxable income each year.
That means that Mike is in the 24% federal tax bracket. And while every state differs, let’s estimate a 6% state tax rate for this hypothetical real world example.
Mike needs $30K to upgrade his home, and is considering taking the money from his 401k.
Assuming he wants to take all funds and expenses from his 401k to actually net the $30K, he will have to take $50K from his retirement plan. Why so much? Let’s take a look…
First, the $50K he takes out will be fully taxable like he earned it working. Since he is in the 24% tax bracket, he will owe $12K in federal tax. Second, he will owe 6% or $3000 in state taxes on the money he is taking out. And finally, to add insult to injury, he will owe $5K for the 10% early withdrawal penalty since he is not yet 59.5 years old.
If that’s not bad enough, the future cost of this withdrawal is astronomical. If Mike left that money in his 401k and it grew at an average rate of 8% till he was 65, that $50K would have grown to $503,132!
That’s quite a bit to give up for a $30K home improvement project.
Of course, there is a time and reason for everything, but maybe there are better options.
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