Tax Advantages and The Disadvantages of Pulling Out Early

I already know what you’re thinking. And you’re right, the 401(k) series is finally back!

I figured you were in need of a little break, but it’s time to get back to “adulting” and understanding how this whole 401(k) thing works. After all, it will be one of your main streams of income in 43 years. Today we’re going to understand the 401(k) tax advantages everyone raves about. We hear why having a 401(k) retirement benefit through our employer is pretty bomb, but has anyone really sat down with you and explained why exactly? Oh, and I’m going to touch on why pulling out too early is not your best option, and this only applies to your retirement savings—get your head out of the gutter!

Tax Advantages

There are tax advantages for both you and your employer when it comes to offering a 401(k) retirement savings plan, but today, it’s all about you. First things first, in Part One I explained a little bit about the tax-deferred benefit of your 401(k) contributions. In short, before you pay Uncle Sam, you pay your future self by investing in your retirement plan. That money is considered “tax-deferred.” It’s good to note that tax-deferred does not mean tax-free. Yes, you’re not paying taxes this year, but you will be paying taxes when you retire and start taking that money out.

In addition, your money can grow free of capital gains tax. What’s that? A typical investment, the ones we make after we pay taxes, will make some sort of return over the course of the year—these are called capital gains. If you sell these assets or rebalance throughout the year, you will be taxed on the gains you made from that asset. In your 401(k), any rebalancing that is done avoids these capital gains taxes; though, when you retire and pull this money out of your 401(k), it will be taxed as if it is regular income. So, you will be avoiding capital gains tax, but not avoiding regular income tax on the money that you make.

You’ll hear people making arguments on whether these tax-deferrals really do benefit us in the long run. The standard assumption is that you'll be in a lower tax bracket upon retirement because you'll have lower expenses and need a smaller income to support that. Whether your taxes go up or down when you retire, I’m willing to bet on the fact that your contribution, plus your company’s match (the one we talked about in Part Two), plus the advantage of gains and dividends growing without being cut down by taxes each year, will generate a much higher income for you in the future, that will far outweigh the stress of finding an alternative option to avoid paying a small increase in taxes.

The Disadvantages of Pulling Out Early

I’m going to keep this short and sweet. If you withdraw money from your 401(k), or any other retirement savings account, before the age of 59 ½, you will be penalized with a 10% early withdrawal that goes on top of any income taxes you have to pay on the money you took out. I highly encourage you to avoid this option at all costs. There are also options to take a loan from your 401(k). Again, avoid these scenarios and vet your other options before considering this.

For more details on the tax advantages and withdrawal and loan disadvantages in regards to your 401(k), email me or shoot me a note on Twitter or Instagram. We’re almost done with our 401(k) series! Move on to Part Four, and if you have any burning questions send them my way! I'll try to answer in my next podcast or blog post.