There are several ways to build an emergency fund to help see you through a seismic life event or an urgent financial situation, but is cashing out your 401k a good option?
In This Article
The Financial Impact of Cashing Out a 401k
Cashing out a 401k may result in several consequences, some immediate and others that you likely will not feel for many years. Withdrawing from a 401(k) before the age of 59½ comes standard with the following:
- A 10% early withdrawal tax penalty.
- Mandatory federal tax withholding of at least 20%.
- The withdrawn amount being taxed as ordinary income, which may cause more taxes being owed, depending on your total yearly earnings, deductions, tax bracket, and other factors.
Is Cashing Out a 401k One of the Best Emergency Fund Options?
Using the equity in your home through a HELOC, taking out personal loans, or slowly building up a savings account to serve as your emergency fund each come with less immediate and long-term economic impact. Cashing out a 401k creates an immediate taxable event (and if under 59 ½ years of age, may also come with that 10% early withdrawal tax penalty).
Cashing out a 401k may also significantly reduce the amount you will have for your retirement and that may potentially elongate your working years. This is because, while your investments may still be growing and compounding, you will have sold all or a portion of those investments in the cash out, thus creating less potential for growth over time.
The Biggest Cost of Cashing Out a 401k
Most financial advisors would agree that cashing out a 401k should be the last resort option for an emergency fund, even if the ordinary taxes due are spread out over three years and the early withdrawal penalty is waived. This is because the biggest cost of cashing out a 401k is, potentially, opportunity cost. In selling 401k investments to fund the withdrawal, you could end up missing out on long-term growth should the stock market recover and continue to flourish at its historical average rate (average annualized return of the S&P 500 Index between 1973 to 2016 was nearly 12%).
Of course it’s challenging to consider the far off future if the present day situation is dire, but do think long and hard about cashing out a 401k and the impact it will have on your ability to retire and enjoy your later years, before taking that step to provide yourself and your family with an emergency fund.