Experts Warn Against Cashing Out Your 401(k) Because It Could Cost You Thousands

If you need cash, what’s the harm in tapping your 401(k) for some extra money? While it may be tempting to cash out your retirement account in a time of need, it can result in a hefty tax bill and negatively impact your long-term savings.

A recent Vanguard study found that in 2023, one-third of workers cashed out their Vanguard-administered 401(k) when they left their job.

We connected with experts to learn more about the consequences of tapping your 401(k) early, when you should consider cashing it out, and some alternatives to taking early withdrawals.

What Happens When You Cash Out Your 401(k)?

When you cash out a 401(k) early, or before age 59½, you may be pocketing some money, but you could also be paying a lot.

“I almost never recommend that someone cash out a 401(k),” said Jason Siperstein, a certified financial planner (CFP) and president of Eliot Rose. “In almost every case—there are exceptions—but you have to pay income taxes and a 10% early withdrawal penalty.”

For example, if you made $75,000 and cashed out a $5,000 balance, you would only receive $3,400 after paying the penalty and federal income taxes—and you might have to pay state taxes, too, depending on the state.

Adam Wojtkowski, a CFP and founder of Copper Beech Wealth Management, notes that if you’re not careful, an early withdrawal could also push you into a higher tax bracket, resulting in a bigger tax bill.

“Whatever [people] are cashing out, it’s hitting their ordinary incomes,” Wojtkowski said. “I would imagine, for a lot of people, that it would probably be a pretty surprising tax bill come tax time the following year.”

Plus, when you take money out, you’re not giving that money a chance to grow and benefit from compound returns.

That $5,000 that you take out at age 30 could be worth almost $74,000 at age 65, assuming an 8% annual return.

“You reduce your [overall] retirement nest egg,” said Siperstein. “You’re solving a problem today, but creating a much larger one tomorrow.”

What You Could Do Instead of Cashing Out Your 401(k)

Wojtkowski and Siperstein warned against cashing out your 401(k) because of how costly it is. Siperstein recommends doing so only during emergencies, like if an eviction occurs.

However, before you take out an early withdrawal, you should consider alternatives. Siperstein suggests using a balance transfer credit card with a 0% APR period on new purchases or taking out a personal loan.

If you don’t have a solid credit score and can’t qualify for any type of low-interest rate loan or financing, you still have options. You could take out a 401(k) loan or take advantage of funds you receive during a 60-day IRA rollover.

These options have different benefits and downsides, so you’ll want to pick the choice that makes the most sense for you.

For example, with a 401(k) loan, there are limitations on how much you can take out (up to 50% of your vested account balance or $50,000, whichever is less) and how long you have to pay it off (five years).

Meanwhile, if you opt for a 60-day rollover, you won’t have to pay any interest, but you would need to have had an IRA with funds in it. Plus, you have to roll it over within a certain time frame (60 days) or risk paying the early withdrawal penalty and taxes.

The Bottom Line

Cashing out your 401(k) should be a last resort. By taking an early withdrawal, you’ll typically incur a hefty penalty and taxes. Plus, you won’t be allowing your money to grow over decades, which could cost you big in the long run.

Instead of taking an early withdrawal, look at other options like a 401(k) loan, a 0% APR credit card, a personal loan, or temporarily using money from a 60-day rollover—just remember to return the funds to a retirement account within 60 days to avoid the penalty and any taxes.