Your 401k might seem like a giant piggy bank just dying to be raided. But you need to take any potential withdrawal into careful consideration.
For some, cashing out the 401k is a mandatory step to help offset bills and other unseen expenses, such as a medical emergency, layoff, or other unexpected expense.
For others, they might see cashing out the 401k as an opportunity to rid themselves of high interest debt, student loan debt, paying off a mortgage or some other non critical move.
There’s even another group that might want to use that extra capital to make a different type of investment, whether it be in real estate, commodities or some other physical asset.
But, before you take this step, you should take a minute to consider each of the following factors:
Penalties for Cashing Out Your 401k
Obviously, if you’re younger than 65 years of age, you’re going to incur severe penalties for taking an early withdrawal.
These can get quite steep, quite quickly. It’s 10% right off the top and you’ll also have to pay taxes on any monies taken out as it’s considered income.
On top of that, it will often raise your tax bracket which means you’ll be taxed at the highest possible rate.
And if that weren’t bad enough, if you live in a state that taxes retirement income, you’ll have to factor that in as well.
Cashing Out 401K: Opportunity Costs
You should also take into consideration the loss of any future gains you might have made had your monies stayed invested in your 401k.
Again, depending on market conditions, these losses can end up being fairly significant.
You want to think of your money like seeds of a tree. If they’re not planted, they’ll never grow.
Cashing Out a 401k: How Much Time do you Have?
We never like to think about our mortality, but when it comes to your 401k, you should be sure to keep this in mind.
If you’re in your 20’s and 30’s, you’ll likely have the time to replenish the monies that you take out of your 401k.
But if you’re in your 40’s or 50’s, your time is already limited. The road to wealth is never a straight line and if you’re not forward thinking here, you may never be able to recoup your nest egg.
Why do you need the money?
Think about what you really need the money for. Whatever the reason, be sure to exhaust all other possibilities before you dive into your retirement.
Some thoughts around typical uses might be:
Eliminating Debt
If you’re paying high interest on debt you owe, your 401k might seem like an easy solution to your problem.
But again, if you factor in some of the negatives outlined above, you’ll realize you might end up paying more in the long run by using your future to pay for your past.
Check out debt consolidation loans or personal loans that allow you to combine all of your debt into one (typically lower) monthly payment.
You might also attempt to contact your creditors and negotiate a lower interest rate or even a restructure of your payment plan.
You might find that creditors are often willing to negotiate. They’d rather take something over nothing.
A Big Purchase
This is likely the dumbest of reasons no matter the purchase.
I’ve seen some use their 401k’s for weddings, cars, boats, even vacation homes. This is the fastest way to becoming an elderly greeter at your local Walmart.
Nothing against those who work there, but I doubt a ton of them love their jobs.
Earn your big purchases in life. Don’t short circuit the path to the good life by buying a piece of it long before you’ve actually arrived. Don’t be the idiot who ends up living in their BMW.
Paying Off a Mortgage with Your 401k
Some people will choose to do this later in life so they can retire without having to make what is likely their largest monthly outlay of cash.
In some instances, this is a wise choice. But only when it’s balanced against what you’ll still need in retirement versus what you have available.
If you think your home is your forever home, project out about ten years. Then twenty.
Do you still see yourself there? Do you still see yourself mowing the lawn? Painting the exterior? Cleaning toilets?
Have you budgeted for property taxes, maintenance, or general upkeep?
You might actually choose instead to sell your home, bank the equity and scale down your living expenses overall.
Unless you plan to become Mr. Fix It in your 80’s, this might not be the choice for you.
You also have to think about how much your portfolio would’ve grown had you kept it in another form of equity.
By paying off your mortgage with a 401k, you’re putting all of your liquid assets into the value of a single piece of real estate (also a fixed asset) which can fluctuate.
Best Reasons to Cash Out a 401k
Some will argue that some of the reasons listed below are still not worth the risk of cashing out a 401k.
Some believe that a 401k is your best option. For most, it is. But for some, your 401k is just PART of your retirement plan.
So here are a few valid arguments for cashing out your 401k.
Investing in a Business/Yourself
I’m a big believer that if you don’t have dreams, you don’t have anything.
At the end of the day, a 401k is just a safety net for the latter years of your life.
But, there are times when it’s appropriate to re-appropriate.
You might have the opportunity to invest in the business of your dreams. It might be something you started or something you’re taking over.
But using a 401k to fund that venture might be the only option you have available. Doing so is risky, certainly, but you’re taking that risk in yourself.
Yes, ultimately it’s a ‘big purchase’, but you’re buying a potential livelihood so it may very well be worth the risk.
Using a 401k to Fund an Education
Like the above reason, an education is just another way to invest in yourself.
If you’ve suddenly come to the conclusion that a master’s degree is in your future and you need to use a 401k to fund that opportunity, then it’s another investment risk worth taking.
And with an education, you may not be buying a livelihood like you would a business, but you’re giving yourself the skills to make that livelihood possible.
And you’ll how to write goodly. (That was a joke.)
Another Investment Opportunity
Stocks, bonds and mutual funds are great, but you might have another opportunity you want to consider for your 401k cash.
No pyramid schemes, ostrich farms or other dumb ideas here please.
But you might want to move some of your 401k capital to another type of asset.
Might be a piece of (positive cash flow) real estate, might be piece of a start up, might be a crypto currency.
All of these are legitimate asset swaps that will help you diversify your holdings and might justify cashing out some of your 401k.
Cash Out Some of Your 401k
You might want to consider diversifying some of your assets anyway, so cashing out some of your 401k might be an option to consider.
But, here you want to avoid taxes and penalties for taking out any cash from a 401k.
So start by setting up a Self Directed IRA transfer a portion of your 401k. You can choose however much you wan to move.
But doing so will allow you to move some the money out of your 401k without incurring the wrath of the IRS.
By setting up a self directed IRA you’ll also expand the type of asset class that currently limits a 401k.
But, the catch is that ALL profits from whatever you’re invested in must stay within the IRA. Until such time that you’re ready to tap into your retirement funds.
Cashing Out Your 401K – Conclusion
So, unless you’re actually entering your retirement years, we don’t really ever recommend cashing out your 401k.
There are a number of legitimate exceptions, but ultimately, it becomes balancing your risk vs reward vs regret scale and deciding the best road for you.
