One of the finest employee benefits in the US is access to an employer-matching 401(k) plan. Under this strategy, both employer and employee contribute to a pension plan under an agreed-upon ratio. For instance, in exchange for contributing six percent of a paycheck, an employer may match up to 75 percent of that contribution. This, along with year-over-year growth from sound investments, allows employees to build for their retirement—for now, tax-free.
That money doesn’t always stay in the account, however. Because it’s their money, employees can make early withdrawals from their 401(k) plans in times of financial need. These withdrawals come at a steep price. Obviously, withdrawn money is “out of play” and can no longer work for its owner. Traditionally, unauthorized early withdrawals are taxable income that also come with a ten percent penalty to the IRS. Nonetheless, such transactions are common. Should employees make early 401(k) withdrawals, even when it seems there is no alternative? We’ll explore this topic further.
Early Withdrawals, by the Numbers
We’ve done the math to show how much employees lose out on by making early withdrawals. Say that a 35 year old earning $50,000 a year withdraws $5,000 from the 401(k). Once the employee has paid federal income taxes and penalties, that $5,000 becomes merely $3,400. Assuming a modest rate of return of just seven percent, this withdrawal also means forfeiting rights to over $38,000 of asset growth by age 65. That’s a steep price to pay indeed.
Why Do They Do It?
Desperate times call for desperate measures, and an early withdrawal from a 401(k) is certainly that. Fortunately, the IRS allows for waiving their penalty under extenuating circumstances. Medical bills, a first home, and disability can allow for withdrawals without penalties. In other cases, the circumstances are such that the IRS doesn’t allow for relief. Generally being strapped for cash is not reason enough. Because of the desperate nature of 401(k) withdrawals, it’s not wrong for employers to suspect something is wrong. Employees could be accessing this money to pay off gambling debts. Worse yet, they could need these funds to cover a burgeoning drug addiction. If you notice that an employee is repeatedly drawing upon 401(k) funds to cover present-day expenses, you may wish to act.
Alternatives to Withdrawal
The bottom line is that there are precious few instances in which employees should make early 401(k) withdrawals. If you’re concerned that an employee is jeopardizing their long-term planning with risky transactions, try to get to the bottom of the issue. Recommend personal loans, lines of credit, or other alternatives that won’t sacrifice retirement.