Cashing Out My 401(k) Early Was a Costly Mistake

It's tempting to cash out your 401(k) if you are facing unexpected bills or a layoff. Losing out on interest and other growth opportunities, however, isn't the only consequence of withdrawing part or all of your balance from your 401(k) plan, as this contributor discovered. Continue reading to learn about why cashing out a 401(k) account is a costly mistake. 

By Lyn Brooks, Writer

Most of us who have 401(k) plans are told upfront by our plan providers to avoid taking early distributions from our 401(k)s if at all possible.

When I lost my job in 2011, and had unexpected medical needs and fell behind on my house payment and other financial obligations, it seemed like the only option that I had to prevent foreclosure was cashing out my 401(k). Since I wasn't returning to work, I assumed that the value of my 401(k), combined with my unemployment benefits, would be less than my earned income from prior years, so I did not plan for any potential tax consequences. This was a mistake.

Most people are knowledgeable enough about 401(k)s to realize that every dollar that you take out of your plan is a dollar that has lost time that it could have been invested, compounding and growing. What you may not realize is that if you take an early distribution from your 401(k) there is a "special" federal penalty tax of 10% on early distributions.

While the investment firm I used held out 10% of the value of my 401(k) for federal income tax purposes, this does not begin to cover the federal tax penalty for the early withdrawal. Also, to make matters worse, if you have taken a loan on your 401(k), and you do not pay it back before leaving your employer, the amount left due on the loan is also counted as a taxable early distribution and is also subject to the 10% penalty.

Each year I have always managed to earn a refund on my federal tax return, but in 2012 I had to come up with a little over $2,500 by April 17th to avoid the additional penalties and interest on my federal tax bill. While my total earned income from the 401(k) distribution and unemployment benefits was less than I usually make each year, the 10% penalty is an unexpectedly significant amount. The entire amount due on my tax bill for 2012 was the 10% penalty for the early distribution from my 401(k).

I cannot stress enough that if you have a 401(k) and you are short of cash that you should try every way possible to avoid taking an early distribution from your plan. If you are like me, and you find yourself without a job and you have no other way, then my suggestion is to run the numbers at the time of your distribution and plan for the 10% penalty that will be due at tax time so you can go ahead and set it aside.

Luckily, my state does not also impose a penalty tax for early 401(k) distributions, but not all Americans are so lucky. My suggestion would be to check with your state to discover if there is also a state penalty tax for the early distribution and plan for that as well.

Since I was unaware of this penalty, I only found out what was due when I completed our taxes, which left less than two months to come up with the $2,500 that was due. A little planning on my part at the time of the early 401(k) distribution in 2011 would have made this a little less financially painful and certainly less stressful.

At the time that I took the distribution, I assumed that I would eventually find another job and easily be able to rebuild my retirement savings. I was very wrong. Three years later, I am now self-employed as a small business owner and struggling, with even less means to begin to rebuild my retirement savings. Cashing out my 401(k) early was not only a costly mistake, it was, perhaps the worst financial mistake of my life. By sharing my story it is my hope that others will learn from my mistake.

Photo Credit: 401(K)2013 and 401K Calculator

Apps and Sites that Let You Shop Without Money

By Lyn Brooks, Contributor

If you are short on cash, you might want to consider using sites and apps that make it easy to share, lend and barter to help you save money on everyday activities. 

Sites My Family Uses to Get What We Need and Want While Spending Little to Nothing in Money

The age old system of bartering to exchange resources is alive and well in America, and several apps and sites make it easy for my family to get what we need or want while paying little, if any, money.

I live in a family of book lovers, and we use to spend $50 to $100 a month on books, but not anymore. We've been able to exchange books for free with other members on BookMooch and Swap.com. Swap also allows you to swap video games, and DVDs, and you just pay for shipping. Both sites have really helped us to lower our cost for entertainment.

When my son moved 500 miles away to attend college in the city, he used Zipcar to rent a car for next to nothing when he needed one for special trips a couple of times each semester.

My oldest daughter saves money on name brand or designer clothing by using Swapstyle to swap clothes with others around the world.

We also use our regional Craigslist to find used items at a low cost. When I was unemployed and our refrigerator, stove and dryer all died within 17 days of one another, we were able to find replacements for $50, $25 and $20 through this site. The appliances look and work great and we are still using them today. Most Craigslist groups also have a Free section -- which is where we scored a free upright piano that was in pristine condition when our youngest daughter wanted to learn to play.

A site that we turn to frequently to find the items that we want and need for free is Freecycle, and the most interesting item that I have ever received also came from this site. This site has literally come to my family's rescue countless times.

Most of the items that I've receive through Freecycle have been fairly straight forward exchanges, but the very first time that I participated really stands out in my mind. One poster listed several bags full of boys clothing to give away, as long as you agreed to take away a "couple of leftover moving sale items as well," as the poster was leaving that afternoon to move to a new state.

I readily agreed and drove into the nearby city to collect the items. I arrived literally as they were closing the doors to their moving van and getting ready to drive off. A very nice lady loaded 3 large trash bags into the trunk of my car and said, "Whatever you can't use, please pass on to someone who can, just don't let it end up in a landfill." She then drove away in the moving van, and I drove home.

Once I got home, I started to go through the bags. In the first bag, there were several pairs of brand name jeans, that were barely worn and fit my son perfectly, as well as several pullovers and hoodies. My son basically had a new wardrobe.

In the second bag there was a really nice, lined khaki jacket with multiple pockets that is perfect for my husband's hiking trips. We looked it up and found that this particular brand costs several hundreds of dollars new, and it was in pristine condition.

In the third bag we found the most surprising and unexpected item -- mixed in with the lady's unwanted plastic storage containers and kitchen gadgets was an object that I didn't recognize. I speculated that it was perhaps some sort of musical instrument -- which made my husband laugh when he corrected me -- it was a pot bong! Of course, we didn't keep that item since its illegal, but it made the experience memorable!

All of these sites have helped us to drastically reduce the amount of money that we spend.

I love receiving feedback from my readers! Have you ever used one of these sites to get a low cost or free deal on something that you wanted or needed? Why not share your favorite sites and apps with your fellow readers so that they, too, can start saving money and begin to get out of debt?

Photo Credit: fontplaydotcom