Personal Finance

With the current economy, I'm considering cashing out my 401(k) despite the penalties — is this a bad idea?

Rich Duprey

Published: December 21, 2024 12:10 pm

Sometimes it feels like it’s not worth even trying. You invest in your 401(k) for years to build up a retirement nest egg, but suddenly everything seems on the brink of rack and ruin. The market looks ready to tank, the economy is going to crash, and there is nothing you can do about it.

Maybe the best thing is to pull your money out of your 401(k) and stick it under your mattress. You’ll have to pay some hefty penalties and taxes for withdrawing your money before you reach 59-1/2 years old, but at least you will have access to your cash when you need it.

That’s the mindset one Redditor on the r/Superstonk subreddit had. At the time, the stock market was in freefall, we were suffering through some of the worst inflation we had seen in 40 years, and the possibility of another “lost decade” like the 2000s seemed possible. The Redditor asked, “what’s the point?”

24/7 Wall St.  Key Points:

• Market corrections are a part of investing, which is why a long investment horizon is necessary.
• Bear markets are relatively short-term events that while painful, will be erased by the bull market that follows.
• Penalties and taxes for early withdrawals from 401(k) plans are stiff and should be avoided.
• Also: Is your 401(k) optimized for your retirement plans? (Sponsored)

Start off with the right mindset

If you’re going to invest in the stock market, you need a long-term investment horizon. You should only invest money you don’t need for paying the bills or for emergencies. Any stocks you do buy should be purchased with the idea of holding them for at least three to five years, but preferably a decade or more.

Market corrections, even crashes, are part of the investing cycle. The beauty of the stock market, though, is that it has always bounced back and gone on to erase all vestiges of the previous downturn. Moreover, bear markets tend to be measured in months while bull markets go on for years.

Data from Hartford Funds shows that stocks, on average, lose 35% of their value in a bear market, but gain 111% during bull markets. If you just leave your money alone during downturns, you might never notice one even occurred. But if you pull your money out, a couple of things will happen.

First, you will lock in your losses. Paper losses are nothing until you actually sell, so pulling out your money ensures you realize them.

Second, you will miss the market upturn. No one can accurately predict when a recovery will start. By having your money on the sidelines means you will likely miss the best days of the market and that will be devastating to your returns.

Hartford found that 78% of the stock market’s best days occur during a bear market or during the first two months of a bull market. By missing the market’s 10 best days over the past 30 years, your returns would have been cut in half. If you missed the best 30 days, your returns would have been gutted by a dramatic 83%. 

The ugly truth of early withdrawals

Feeling momentarily glum about a situation isn’t good enough to withdraw your 401(k)’s funds. The penalties and fees are substantial.

Early withdrawal penalty. There’s a 10% early withdrawal penalty on the amount withdrawn if you’re younger than 59-1/2. This penalty is in addition to the income tax you owe. 

Withholding. The IRS requires 20% of the distribution to be withheld for federal income taxes unless you roll over the funds directly into another qualified retirement plan or IRA within 60 days. However, this withholding might not cover your full tax liability, especially if you’re in a higher tax bracket.

Income tax. The amount you withdraw is considered taxable income paid at ordinary income tax rates. The exact rate depends on your total income for the year, potentially pushing you into a higher tax bracket.

Taken together, you could be looking at paying up to 30% or more in taxes and penalties on the withdrawal amount.

Key takeaway

It’s natural to feel down when the market starts going against you, but that’s why you need to invest for the long-term. And by avoiding investing money you need to pay bills, you’re not under pressure to withdraw funds from your 401(k) early.

Because the penalties and taxes for early withdrawals are stiff, you should not do it as you will harm your long-term portfolio returns.