Earlier this week I engaged in Forum debate over an early 401(k) withdrawal. The person asking the question really wanted to break into real estate and was wondering what the crowd thought about taking an early 401(k) withdrawal, commonly known as a “hardship” withdrawal. My inner CPA took over, and I attempted to explain why I thought this was a bad idea.
I’m going to save my thoughts on contributing to a 401(k) for next week. Right now, I want to focus purely on whether or not it makes sense to take a hardship withdrawal.
I’ve run the numbers and offer them to the BiggerPockets community as proof that I was both right and wrong. I argued two premises: (1) that the 401(k) early withdrawal is extremely costly and (2) that if you have to take a 401(k) withdrawal, you may want to focus on improving your financial situation prior to jumping into real estate. While I stand by my second argument, that if you have to take a hardship withdrawal from your 401(k) you shouldn’t get into real estate, my first argument was incorrectly stated. I should have argued that the 401(k) withdrawal is extremely costly in the short run. Here’s why.
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Taxes, Taxes, Taxes
An early 401(k) withdrawal is subject to your marginal tax rate, plus a penalty rate of 10%. A common misconception is that your withdrawal will be penalty free as long you are purchasing your first house with it. While it’s true that this exception exists for IRA withdrawals, the exception is specifically excluded for 401(k)s.
If you take a $10,000 withdrawal to help aid your purchase of real estate, assuming your marginal tax rate is 25%, the tax on the withdrawal will be $3,500 (25% + 10% penalty), leaving you with a real value of $6,500 after the withdrawal.
A poster in the Forum made the point that you wouldn’t pay taxes on the withdrawal until April 15th the following year. This will allow the person to accrue earnings on the money, assuming it was invested until that time. A good point indeed, but it comes with flaws.
For instance, if you were to sink the $10,000 into property, an illiquid asset, and come tax time you have an extra $3,500 due – will you have the ability to pay for that tax? You can’t just draw the money out of the property. Since you took a hardship withdrawal, you likely have little in reserves. So how do you pay for it?
Additionally, in order to accrue earnings on the withdrawal to cover that whopping tax bill at year end, you have to assume that it was immediately invested in order to give the growth enough time for the withdrawal to make an ounce of sense. How often have you seen a closing happen so perfectly that you’d feel comfortable timing your withdrawal down to the day? That’s what I thought.
Foregone Earnings: The Hidden Cost (in the Short Run)
Forgone earnings are very real, especially when talking about retirement withdrawals. The impact to your finances can be massive, but generally only in the short run. What is the short run? Well that depends on how well you reapply your capital and at what rate earnings are accruing.
Say your 401(k) grows at a 6% rate each year. By taking a $10,000 withdrawal, you lost out on $600 of earnings. So now you have to reapply that capital as quickly as possible in order to make up for those lost earnings and cover the pesky tax cost of the withdrawal.
The total cost of your withdrawal will be $4,100 ($3,500 in taxes, plus $600 in lost earnings). There’s no way around that cost. Assuming you are able to reapply your capital quickly, can you make a 41% return on your $10,000? Probably not.
What if you don’t reapply your capital quickly and tax time rolls around? Now your $6,500 in post-tax withdrawal has to make a 63% return just to break even. See how costly this 401(k) withdrawal can get?
Let’s take this a step further. What we haven’t factored into the math is the continued earnings on the $10,000 if left in your 401(k). So let’s assume your 401(k) will continue to earn 6%, but if you draw the money out, you can reapply the post-tax money ($6,500) at a generous 12% rate. Under these assumptions, it will take you seven years to simply break even on your withdrawal decision. That’s a long time just to break even. Don’t believe me? Take a look at the numbers:
But this is a double edged sword, and this is where I should have clarified my argument. You see, after seven years, the decision to withdraw the money today actually benefits you — and benefits you dramatically. At the end of 20 years, your $6,500 withdrawal will have grown to $62,700, whereas if you had left it in your 401(k), you would only have $32,000. But remember, the stark difference is due to your ability to successfully reinvest the capital. I applied a rate of 12%, which may or may not be achievable for an amateur real estate investor.
It’s Too Expensive; Here are a Few Solutions
As you can see, a hardship withdrawal from your 401(k) is simply too costly a solution to your money problem. It will take you seven years just to break even on your decision. That’s a long time and a big risk.
A poster mentioned that it’s only a couple grand, so what’s the big deal? True, it’s a small number, but the real indicator of whether or not this move makes sense can be measured on a percentage basis. Measuring decisions on a percentage basis levels the playing field and allows a transparent look at how the decisions will pan out. For instance, making $1,000 off a $10,000 investment is generally a good return. But making $1,000 off a $100,000 investment is considered a poor return. We returned the same dollar amount, but the percentage return varies drastically.
I measure all financial decisions on a percentage basis. Percentages can be applied to every financial decision, regardless of the amount of capital involved. Applying a percentage to the 401(k) early withdrawal shows at least a 35% loss on the withdrawal. Add in the foregone earnings of 6%, and now we are at a 41% loss. I don’t know a single person that would claim taking a 41% haircut in year one is a smart idea.
The immediate solution is to simply stop contributing to your 401(k) and get your finances in line. This way, you avoid the 10% penalty fee on your money and the foregone earnings on the principal amount in your 401(k).
The second option is to take a loan from your 401(k). You can loan yourself $50,000 or half of your balance, whichever is less. The loan has a timeline of 5 years, unless applied to a primary residence, and you must pay yourself interest. The downside here is that most plans require you to pay the loan back within 60 days of leaving your job.
The third option is to leave your job and roll your 401(k) into an IRA. You will have more flexibility with your investment options, and you will have the ability to choose low cost funds.
I’ll talk about the company match and whether I think a 401(k) is a good overall investment vehicle next week, but my overarching point is that a 401(k) early withdrawal is simply too costly and should be avoided at all costs. So costly that it takes seven years to recover from your decision. Play smart, folks!
Investors: Do these numbers surprise you? Where do you stand on this Forum debate?
Let me know your thoughts in the comments section below.