Early 401(k) Withdrawals May Reduce Your Savings by $100K. Discover Ways to Protect Your Retirement Funds

Main Insights

• Tapping into your 401(k) through a loan or withdrawal means missing out on potential investment gains.

• Taking money out reduces your principal, which can significantly limit the benefits of long-term compounding.

• Replenishing your retirement savings after a withdrawal is often more challenging and time-consuming than anticipated.

Recent research from Fidelity Investments shows that rising living expenses are a major source of stress for 75% of employees.

For some individuals, this financial pressure leads them to consider withdrawing funds or taking a loan from their 401(k). While this may provide short-term relief, it can have serious long-term consequences. Even a small early withdrawal can reduce your retirement savings by tens of thousands of dollars over time due to taxes, penalties, and the loss of compound growth.

Employees Without Emergency Funds Are Twice as Likely to Borrow from Their 401(k)

Fidelity’s findings also reveal that workers lacking an emergency fund are about two times more likely to take out loans or make early withdrawals from their retirement accounts.

As more employees use retirement savings to cover unexpected expenses like medical bills or housing, the absence of emergency savings puts both their financial future and retirement timeline at risk.

Important Update

The proportion of individuals making hardship withdrawals has climbed to roughly 5% in 2024, up from 2% in 2018. The number of 401(k) loans has also been on the rise since 2021.

Comparing 401(k) Withdrawals and Loans

It’s crucial to understand the differences between hardship withdrawals and loans from your 401(k). With a withdrawal, you remove funds directly from your account, which are taxed as regular income. If you’re under 59½, you’ll typically face an additional 10% penalty unless you meet an IRS exception.

A 401(k) loan allows you to borrow against your retirement savings. The borrowing limits are:

• Up to 50% of your vested balance or $10,000, whichever is greater

• But no more than $50,000 in total

Typically, you must repay the loan plus interest within five years, unless the funds are used to buy a home. Unlike withdrawals, loans are not taxed or penalized, and the interest you pay goes back into your account. Even if you miss a payment, your credit score is not affected.

However, both options have significant drawbacks. While your money is out of the market, you forfeit potential investment returns. If you leave your job, you may have to repay the loan quickly—sometimes by the next tax deadline. Failure to repay means the outstanding balance is treated as a taxable withdrawal, with a 10% penalty if you’re under 59½.

The True Cost: Over $100,000 in Lost Retirement Savings

To illustrate the impact of compounding, consider this: withdrawing $10,000 at age 35 could have grown to about $76,000 by age 65, assuming a 7% annual return. After taxes and penalties, you might receive only $7,000 now, but you’d be sacrificing around $70,000 in future value.

Similarly, taking a $25,000 loan from your 401(k) at age 40 could result in approximately $136,000 less in retirement savings by age 65, factoring in missed growth at a 7% annual rate.

Even though you’re borrowing from yourself, you’re interrupting your investment’s growth. In a compounding market, every year you miss out on growth creates a permanent setback.

Better Options Than 401(k) Loans or Withdrawals

If you’re facing financial hardship, consider these alternatives before touching your retirement savings:

• Establish or maintain an emergency fund: Aim to set aside three to six months’ worth of expenses. This safety net can help you avoid dipping into your 401(k) during tough times.

• Explore personal loans or a HELOC: If you have good credit, personal loans or home equity lines of credit (HELOCs) may offer favorable rates and flexible repayment options, allowing you to preserve your retirement savings.

Final Thoughts

While borrowing from or withdrawing early from your 401(k) might solve an immediate cash crunch, the long-term consequences can be severe. Taxes, penalties, and the loss of decades of compound growth can reduce your retirement savings by tens or even hundreds of thousands of dollars.

Remember, your 401(k) is designed for long-term growth—not as a backup fund for emergencies. Consider all other options before accessing these funds. Protecting your retirement savings today is crucial for your financial security tomorrow.