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What are the Pros and Cons of a 401k Early Withdrawal?

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  • Written By: N. Madison
  • Edited By: Jenn Walker
  • Last Modified Date: 07 September 2016
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A 401K plan is a type of retirement savings plan a person may use to prepare for his needs once he is ready to stop working. Sometimes, however, a person may need to withdraw money from a 401K plan before he has reached retirement age. In such a case, however, he may face penalties for 401K early withdrawal. The main pro of taking a 401K early withdrawal may be gaining access to a lump sum of money in a time of need. The cons, however, may sometimes outweigh this pro, as taking an early withdrawal may translate into hefty financial penalties and less money available when the time comes to retire.

For a person who needs money and cannot get it from another source, a 401K early withdrawal may seem like a good idea. Often, people take early withdrawals to pay for things such as college educations for their offspring or buying a new home. An individual may also have a need to take an early withdrawal to pay off debts or pay medical expenses if he has no other source to cover such needs. Sometimes an individual may also choose early withdrawal because he is retiring early and wants to have money for retirement sooner rather than later.

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A 401K early withdrawal can provide money in a time of need and free a person from having to borrow funds or simply do without. Unfortunately, however, a person who wants to take an early withdrawal typically has to pay taxes and penalties on his money. In most cases, a person will have to pay income taxes on his withdrawal. This can be a sizable sum on its own, but a person who wants to withdraw money from his 401K plan before he reaches 59 and one half years of age may also have to pay a 10-percent early withdrawal penalty.

If an individual decides to retire early, he may be able to escape the early withdrawal penalty. He would typically have to withdraw a fixed amount for a specific number of years, however. This amount would usually be based on the 401K holder's life expectancy. An individual may avoid an early withdrawal penalty this way, but may still be responsible for income taxes on the money.

In addition to paying income taxes and penalties for taking a 401K early withdrawal, there are other things that make the early withdrawal of funds less advantageous. If a person takes some of his money out early, he cannot take advantage of future investment growth. In addition to the chunk of money the person may withdraw, this loss of investment growth may further deplete the money he will have for retirement.

When faced with the limited benefits of 401K early withdrawal as well as the weighty cons, some people may decide that taking a 401K loan is a better option. There are borrowing limits and restrictions placed on the length of time a person can take to repay such a loan, but there is no credit check required. The loan repayment, including interest, goes back into the 401k borrower’s account, which means the borrower protects his retirement savings. For many, this may be a more financially beneficial option than taking a 401K early withdrawal.

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