Taxes and penalties can significantly reduce the amount you end up with.
Early withdrawals are subject to federal income taxes, and depending on where you live, state income taxes. Also, depending on the type of plan the funds are withdrawn from, you may have a 10% penalty tax as well (457 plans are not subject to the 10% early withdrawal penalty).
Consider this example:
A 45-year-old investor in the 22% federal income tax bracket who withdraws $25,000 from their 401k plan while still employed will owe a total of $8,000:
- A $2,500 10% early withdrawal penalty
- $5,500 in federal income taxes
In the end, theyāll only net $17,000 of the $25,000 they took out. Plus, theyāll pay more in taxes than they might have in retirement, when they may have been in a lower tax bracket.
Youāll miss out on compound growth, making it harder to reach your goals.
Money that doesnāt stay invested loses the chance to grow through compounding (when your earnings make more earnings of their own). Ultimately, that means youāll need to save more money out of pocket to hit your savings target.
Consider this example:
A 35-year-old investor withdraws $10,000 from their account. If that money had been left in that account until age 65, and earned a 10% average annual return, it wouldāve grown into almost $175,000. So, the true cost of the $10,000 withdrawal is much higher when you consider the growth they have now missed out on.
You may have less to live on in retirement.
Experts say you need to replace about 80% of your pre-retirement income to maintain your standard of living as a retiree. Social Security may replace less than 40%. If you withdraw money now and donāt have sufficient savings when you retire, you could face a shortfall between the amount you have and the amount you need. This could impact your quality of life throughout retirement.