Taking an Early Withdrawal From 401(k) - Does it Make Sense?

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Taking an Early Withdrawal From 401(k) - Does it Make Sense?

By JLP | May 17, 2007

Here’s an email I received from a reader:

I’ve been a passive reader of your blogs for quite sometime and i’ve a learnt a lot about finance.

I am Indian student in F1 visa status. I recently got a job and I plan to work for around 5 yrs in H1B status before I go back to India. I don’t want to settle down in the US until my retirement. My company offers 401(k). For the first 3% they match every dollar, the next 2% they match 50 cents on the dollar. I don’t want to lose the free money from my employer. Is it worth investing in 401(k) even after knowing that I will be taking the money before retirement and will be paying the tax and penalty when I withdraw it? I want to know if I could profit, even after taxes and penalty, from the free money that my employer matches. My gross salary is 78k and I’m in the 28% tax bracket.

-Dreamer

Interesting question and I like a challenge so I decided to take it on. Now, since I’m not getting paid for this, DON’T take this example as advice. It’s merely an exercise to see what could happen in a situation like this.

Here’s what I came up with:

First off, I know nothing about F1 status or H1B status and have no idea whether or not any of this would have an impact on the outcome of this situation. Also, I have ignored Social Security and Medicare in this situation. Here’s some other assumptions I made:

The $78,000 salary remains the same for the 5 years.

The 401(k) grows at 8% per year. To compute this I simply took the year’s ending balance and grew it at 8% and then added the next year’s contributions to it. It’s not precise but it will work for this example.

I used 2007’s tax brackets, personal expemption and standard deduction throughout the example.

In year 6 I assumed his only income would come from the termination of the 401(k). If he had additional income that year, it could have a huge impact on his tax situation.

So that represents his five years of working. Now let’s see what could happen when he withdraws the money. Remember that an early withdrawal from a 401(k) is taxed as income AND is assessed a 10% penalty (except in certain situations that don’t apply here).

So, according to my math, he will contribute $19,500 (his personal contribution not including company match) into the plan over 5 years and get to keep $33,758 when he terminates the plan and pays the taxes and penalty on the withdrawal. It would be better to keep the plan as is and let the $41,184 grow but I’m not sure if this option is open to him. Also, keep in mind that the plan provider may withhold 20% of the balance, which he will get back the difference once he files his taxes.

Dreamer, I hope I answered your question. Now, take this with a grain of salt and go see your CPA.

Topics: 401(k), Tax Planning, Taxes |

Comments to “Taking an Early Withdrawal From 401(k) - Does it Make Sense?”

vg Says:
May 17th, 2007 at 12:11 pm

Thanks for the insight JLP, I am in a similar situation.

broknowrchlatr Says:
May 17th, 2007 at 12:29 pm

I know someone who is in exactly the same situation. For tax purposes, and alternate option is to take annual payments of $14,100. Then, no tax will be due.

Whether or not you will retire in the US, I think you can still keep the 401k, which is the best option of all.

samerwriter Says:
May 17th, 2007 at 12:35 pm

I agree with the above commment. I don’t know how taxes work for foreign workers, but if you are a citizen, it can often be advantageous to contribute to a 401k even if you need the money soon, then withdraw the money in a low tax year. That is true even if you don’t have an employer match.

In other words, use the 401k as a tax deferral vehicle. The 10% penalty sucks, but if your tax rate is dropping appreciably, it’s still quite easy to come out ahead (particularly if you live in a high income tax state).

Nigel Says:
May 17th, 2007 at 4:55 pm

He may be able to do better.
1. Roll over the 401(k) to an IRA when he leaves his job.
2. Convert to a Roth IRA after he leaves the US, when he has no other income from US sources. If he does this over several years, little or no tax may be due.
3. The contribution portion of the Roth may be withdrawn tax and penalty-free anytime. The 10% penalty will be due only on the earnings.

EMF Says:
May 17th, 2007 at 6:01 pm

However on a conversion there’s a waiting period (5 years IIRC) before withdrawals of converted amounts can be done without a penalty.

Dreamer Says:
May 18th, 2007 at 12:53 am

Thank you JLP for your time and research. I’ll make the contributions as advised.
I thank others for giving their valuable inputs.
AllFinancialMatters has been one of the biggest resources for my financial decisions.

-Dreamer

Nigel Says:
May 18th, 2007 at 9:00 am

EMF, you are absolutely right.

Dreamer, a bigger concern for you should be Indian taxes, since India taxes its residents for their world-wide income, and a 401(k)/IRA withdrawal will count as income for you. Depending on your tax bracket, this may be quite significant. You will need an accountant in India to help with this.

try2bekuber Says:
May 18th, 2007 at 2:08 pm

Good post JLP. I was in the same situation as Dreamer 7 years ago. I went through my analysis in a similar way and arrived at the same conclusion. The difference though is that, when you are on a H1-B visa, you do have to pay social security and medicare. If you include that in your calculations, the numbers change a little bit, but not enough to sway from investing in 401k.

Tim Says:
May 18th, 2007 at 3:13 pm

The glaring problem with all of these suggestions is that the Dreamer has not asked the employer (or didn’t include it in the post) what options are available upon termination of employment. if the employer allows Dreamer to keep it in the employer 401K plan, the employer may tack on or pass along maintenance fees which were not added to the calculations above; moreover, if the employer does not keep the 401k and Dreamer keeps it there, the employer could automatically transfer to the owner of the plan which would incur 20% tax, in addition to the 10% early withdrawal and other taxes depending on Dreamer’s tax bracket. so check with HR to see what your 401k options are post-employment (BTW they are required to send options 30-90 days)

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May 19th, 2007 at 11:46 pm

[...] All Financial Matters answers a reader’s question as to whether an early 401(k) withdrawal makes sense. [...]

Some Link Love For Good Articles In the Past Week by Money Crashers Says:
May 20th, 2007 at 9:53 pm

[...] JLP from All Financial Matters asks the question if dipping into your 401(k) early makes sense? [...]

Cricket Says:
July 13th, 2007 at 7:50 am

I am a newbie here…didn’t know there were PF blogs. I have a question: What about paying the tax on the contribution UP FRONT so only the interest is taxed and not the principal and interest at withdrawal?

Just asking…and I am a semi DR fan.

Marc Says:
July 23rd, 2007 at 10:07 pm

Are 401k disbursements taxable on state income tax?
I work in California. Also, I’ve read somewhere about a flat rate of 30% federal income tax if one takes the money out when he/she is not anymore a resident is this true?

Redrick Saggard Says:
October 21st, 2007 at 1:59 am

I have doubts about many suggestions presented here. Why do people praise the authors so much is truly beyond me. None of the people considered a simple alternative of withdrawing from 401(k) entirely and investing in an index mutual fund. Pick a fund that invests in Europe and/or Asia (which invests in basket of currencies), and factor in the weak dollar situation (which is unlikely to change over the next 5 years). For estimates, you can pick the returns of Vanguard funds over the last 5 years. This H1B may lose on taxes with his 8% return of 401k minus 10% penalty, but gain a lot on 15% - 20% return of the index mutual fund with no penalties and no hassle to move around the world.

Jai Says:
October 21st, 2007 at 12:00 pm

First of all the analysis is right on. However, some additional info. As a non-citizen if you leave the country after having worked on a H1B have three options for your 401(K):
1) Keep the 401(k)(most employers will let you do that if you have a minimum amount in it.
2) More often than not the 401(k) does not have low-cost funds and/or does not have all asset classes. In that case, roll over the 401(k) to an IRA an invest it in a diversified portfolio of low cost funds (My preference is Vanguard and index funds). You can go one step further and roll this over to a Roth but will need to pay taxes - both Indian as well as US but you may be able to minimize them if you time your exit & conversion properly.
3) Withdraw

As someone in a similar boat the most attractive option in #2 - rollover to an IRA in Vanguard while #3 is the least attractive.

Two reasons why withdrawing is not such a good option:
1) 401(k) is retirement money, so let it be there for long term retirement uses. By withdrawing you will invariably use it for some “emergency”
2) Will you have diversified investment options in your home country? Is it easy for you to invest in non-indian funds in a low cost manner? If not them the IRA in the US could provide you with a diversifying element in your portfolio assuming you have an asset allocation plan.

In general irrespective of where you retire you will need a retirement income to come from your investments. The sooner you start saving the better - do not let your future possible career decisions stop you from investing now because compounding time lost now will hurt you the most later.

To Redrick : The analysis was for the free 3% that the employer matches. What part of the author’s analysis do you have an issue with? You have a point in that beyond the 3% match the OP could invest in a taxable portfolio of low cost index funds. But that is a different question & analysis.

early withdrawal from 401 k Says:
May 25th, 2008 at 12:12 pm

[...] Does it Make Sense? … Remember that an early withdrawal from a 401k is taxed as income AND is …http://allfinancialmatters.com/2007/05/17/taking-an-early-withdrawal-from-401k-does-it-make-sense/Considering a withdrawal from your 401k? - WTOL… they&39re literally cashing out part of their [...]

401k early withdrawal Says:
May 25th, 2008 at 5:14 pm

[...] [...]

Diane Says:
January 5th, 2009 at 11:03 pm

I have a 401k thru Fidelity and my company.
I want to take out money with out a hard ship.
They are telling me no. I told them I would pay the penalty. Can you give me some advice on what to do next. They have said no to a

NELL Says:
March 19th, 2009 at 8:35 pm

THE PAST SEVERAL QUARTERS WE HAVE LOST APPROX. 15,000. IN OUR 401K SAVINGS DUE TO THE STATE OF THE ECONOMY AND WE WANT TO REMOVE IT AND PAY OUR BILLS BEFORE WE HAVE NOTHING LEFT IN THERE AND WE CAN’T TOUCH IT WITHOUT PENALTY.I THINK WE HAVE BEEN PENALIZED ENOUGH AND IF WE WAIT TILL MY HUSBAND IS 59.5 THERE WILL BE NONE THERE FOR US TO USE. WE LOST 7500. LAST QUARTER ALONE AND WE AREN’T GOING TO GET THAT BACK. ANY SUGESTIONS AS TO HOW WE CAN GET THE BEST USE OF IT BEFORE IT IS GONE. WE NEED TO USE IT OR TAKE OUT A LOAN AND I THINK IT WOULD BE BEST TO USE THE MONEY WE HAVE THAN TO BORROW ON SOMETHING THAT IS RUNNING AWAY FROM US JUST AS FAST AS IT CAN. WE REALLY NEED SOME ADVISE AS WHAT WOULD BE IN OUR BEST INTEREST.
THANKS. I THOUGHT 401K WAS FOR RETIREMENT, WELL WE ARE RETIRED WHY CAN’T WE USE IT.

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Taking an Early Withdrawal From 401(k) - Does it Make Sense?