This new post comes from a real story I heard this past week at work. As many know, work (especially in the therapy gym) is the common place for all sorts of different stories, understandings, thoughts, conspiracies, and beliefs to be shared freely. Most people don’t want to hear your political, religious, or financial advice but work gives people a nice buffer to express freely without as much kickback, especially if you are the customer.
This holds even more truth in the healthcare field, especially when you spend 10+ hours with one patient by the end of their POC as we do in PT frequently. Although I do enjoy hearing people’s counter beliefs to my own as it helps me to better understand others views, I have perfected the “I can see that” or “that makes sense” response with a straight face when in reality I’m usually in shock at some of the things that people say freely
So how does this apply to withdrawing from your 401k?
Well, this week’s patient story was about how they and much of the town they live in were using the updated 401k withdrawal rules during COVID-19 to get early access to their retirement funds.
But let’s back up and explain these new rules if they are unfamiliar to you.
CARES Act: Updated 401k Withdrawal Rules
Most of us have heard about the stimulus checks and the expanded unemployment rules but one of the less talked about updates in the CARES Act was to the 401k withdrawal.
A 401k, as most of us know, is an employer provided retirement account in which your employer may or may not contribute a certain % to as a benefit of work.
This account is pre-tax meaning that when you contribute to this account, the money is not taxed and pulled directly from your paycheck. This allows your money to grow tax free, but you will be required to pay taxes on this money when you withdraw it. However, the thought is that you will be in a lower tax bracket when you retire than during your working years making the tax burden less.
Normally, this money cannot be withdrawn from your 401k before the age of 59 ½ without a fee. If you do access this money early, you’ll be charged with a 10% fee along with taxes on both the federal and state level.
So if someone was already making over $40,126 per year, any additional income from a 401k withdrawal will be taxed at another 22% minimum. And this is without the potential for additional state income tax.
Meaning at least 32% of your retirement withdrawal is going to Uncle Sam. Possibly more if you are in a higher tax bracket.
New Rule
With the new CARES Act, you can withdraw up to $100,000 without the 10% penalty AND you are allowed to distribute this taxable income over the next 3 years to spread out the tax hit.
However, if you pay back this withdrawal in 3 years, you will be able to claim a tax refund on those taxes.
401k participants will also have the ability to withdraw up to 100% of their vested balance (previously 50%) as a loan in which payments can be delayed for up to one year.
So, you can see right away how helpful this could be if you are in need of money to get yourself and your family through these tough times. This could be used for basic needs like food, shelter or even to avoid falling into high interest credit card debt.
However, that’s not how everyone is viewing this benefit.
Back to the Story
As I sat in the therapy gym, I listened as a patient explained these new updated rules. They explained that the penalty was waived and they could spread out the withdrawal over 3 years.
This patient went on to explain that they and the many other families that were taking advantage of this rule change weren’t doing so out of financial crisis/need but rather financial want.
They explained that due to COVID-19 their company stopped matching any contributions to their 401k for the time being so keeping their money in the account didn’t make sense any more. Plus, when would they have another opportunity to access THEIR money again like this?
Specifically, this patient explained that they withdrew a large sum of money from their 401k to boost their savings account as this way they knew that they wouldn’t lose any more money in the stock market. They went on to explain how others have done the same to purchase new trucks, new toys, to pay off their house or vehicles etc.
In this moment I wished I could at least gave them all of the information regarding this financial decision but this is not my place and people are allowed to make whatever financial decisions they choose. So I bit my tongue.
Below is everything that I wanted to explain about this decision.
Why You Should Not Withdraw From Your 401k?
Taxes:
Although the 10% early withdrawal fee is waived, you are still on the hook to pay taxes on this money you are accessing. So let’s use an example to explain how this will affect you financially.
Scenario 1
Meet John. John is the average american who makes an average income in the United States of $59,000 per year. John, like the people in our story, decided to withdraw $75,000 from his 401k, distributing $25,000 per year. John is single so he receives a standard deduction each year of $12,400 bringing his taxable income to $46,600. For simplicity, John pays 5% state income tax.
In this scenario, John’s 401k withdrawal will be taxed at a total of 27% as John’s total taxable income for the next 3 years will be $71,600. His initial $46,600 plus his $25,000 from his 401k withdrawal, putting him in a 22% tax bracket. Plus a 5% state income tax.
John will pay $6,750 per year in taxes for the next 3 years on his 401k withdrawal. Meaning of his $75,000, John will only receive $54,750.
Summary:
- Pre Tax 401k Withdrawal: $75,000, distributed over 3 years
- Post Tax 401k Withdrawal: $54,750
- Taxes Paid: $20,250
Scenario 2
Now, let’s say John retired at 60 and wants to begin withdrawing from his 401k. He decides that he is going to withdraw the same $25,000 per year. Because John is over 59.5, he no longer has a 10% early withdrawal fee, but everything he withdraws will be taxed in the year he withdraws it.
In this scenario, John still has the same $12,400 deduction bringing his taxable income down to $12,600 per year. This puts him in a 10% tax bracket for $9,700 and a 12% tax bracket for the remaining $2,900.
John will now pay $1,948 per year in taxes over the next 3 years. Meaning of his $75,000, John will receive $69,156
Summary:
- Pre Tax 401k Withdrawal: $75,000, over 3 years
- Post Tax 401k Withdrawal: $69,156
- Taxes Paid: $5,844
Difference: $14,406
And I can hear everyone, no one could live off of $25,000 per year. I counter this that many people have supplemental income, a partner, lower cost of living in retirement, etc. So this withdrawal may not be as far fetched as it may seem.
However, even if you withdrew $40,000 per year, you would only pay $6,606 in taxes each year. Meaning over 3 years you would withdraw $120,000 from your 401k and only pay $19,818 in taxes over this span. Which is still less in taxes than if you withdrew that money now.
Compound Interest
Obviously my favorite point in this discussion, as who doesn’t love some good compound interest calculations. So let’s use John again for our example.
Scenario 1
In this scenario, John decides to access his 401k early per the new CARES Act. John doesn’t plan to spend this money right now, but he does feel safer knowing his money isn’t going to keep dropping in the unpredictable stock market like it did while it was in his 401k.
John doesn’t see why he would wait until he is 60 to access this money when the government is letting him access HIS money now.
He decides to withdraw the same $75,000 above and distributes the income over 3 years. Which as we have shown above, results in an extra $54,750 in his savings account.
John is 35 and plans to work another 15 years before he retires well before his colleagues at the age of 50. Another reason why John feels he needs to withdraw this money now before the government adds the 10% penalty back.
John stores his money is his savings account which returns the national average interest rate for a savings accounts at 0.09%. At the end of the 15 years, this money has grown $744, up to $55,494.
Summary:
- Pre Tax 401k Withdrawal: $75,000, distributed over 3 years
- Post Tax 401k Withdrawal: $54,750
- ROI: $55,494
- Difference: +$744
Scenario 2
Now let’s say that John forgot his password to his 401k account and was forced to leave the same $75,000 in his 401k to grow tax free. Let’s assume a conservative 7% return on investment (ROI) over the next 15 years. Note: The average S&P 500 return since inception is 9.8, so 7% is a conservative return accounting for inflation.
In this scenario, John doesn’t look at his 401k until he retires 15 years later. To John’s surprise, this money has grown to $206,927.
Summary:
- 401k Balance: $75,000
- 401k balance after 15 years: $206,926
Difference: +$131,926
By keeping his money invested, John is letting his money continue to work for him and grow tax free. In this scenario, he made over $131,000 more by leaving his money invested than moving it to his savings account.
Although he won’t be able to access this money penalty free until he is 60, John’s money has nearly tripled allowing for a much safer retirement. Note: There are ways to access this money before this point penalty free as well, but that is beyond the breadth of this post.
Even if John used his early 401k withdrawal money to pay off his house or car, the ROI is still higher to leave his money in his 401k. You can read more about that discussion in my previous post: “Should I Pay Off My Mortgage or Invest?”
Selling Low
Finally, the last thing to think about when withdrawing money early from your 401k is that you are selling at the bottom of the market or at least at a strong dip. Meaning that you are selling off your 401k shares at a loss.
There is a reason that the government is letting people access their 401k early without penalty. It’s because the country is in an economic downtown and many people need access to these funds to stay afloat.
So in turn the stock market is also in a downturn which is why people have a hard time not intervening when they see their 401k dropping by thousands of dollars each day. Thankfully, I have already created the “Ultimate Guide to a Stock Market Crash” to help with this sort of thing.
So let’s see what John’s options are.
Scenario 1
John, like many, is sick of losing thousands of dollars in his 401k. So to stop the bleeding, John decided to take advantage of the new CARES Act rules and withdraw from his 401k.
At the market high, John had $75,000 in his 401k. When John withdrew from his 401k, the market had already dropped 20%. Thankfully, John got out early enough to miss the market low of 30%.
So when John pulled his money out, John was able to withdraw $60,000 before taxes compared to only the $52,500 he could have accessed if he would have tried to get out of the market a few weeks later.
John feels like he dodged a major bullet that saved him almost $8,000 of his money and he now feels much less stressed not having to watch his money dwindle.
Summary:
- Initial 401k Balance: $75,000
- 401k Balance at withdrawal: $60,000
- Potential 401k Balance at market low: $52,500
- Saved Money: +7,500
Scenario 2
Again, John is very concerned about how rapidly his money is declining in his 401k. John’s boss stopped contributing to his 401k due to COVID-19 and John wants out now before his retirement money is gone completely.
However, like before, John can’t find his 401k password. He is extremely worried. A few weeks go by, and then a month. John starts to see his money begin to go back up. It continues to go up to the point that it sits at today, down only around 10% from the previous market highs earlier this year.
He is confused but happy. Of his initial $75,000, John is only down $7,500 as his 401k now sits at $67,500. He realizes that if he had sold when the market was down 20%, he would have avoided the dip to 30% but would have missed the quick rebound back to down only 10%.
By not selling, John actually has $7,500 dollars more in his 401k than he did in scenario one.
Summary:
- Initial 401k Balance: $75,000
- 401k Balance Currently: $67,500
- 401k Balance When John Wanted to Withdraw: $60,000
Difference from Scenario 1: +$7,500
Conclusion
I will never tell you what to do with your own money but I will always make sure you have the best, numbers backed information available to you so that you can make the best decision for you.
And unless you are struggling with financial hardship, the numbers strongly suggest not withdrawing from your 401k.
So in conclusion… Please Don’t Withdraw Your 401k
