So You Want to Be an Entrepreneur? Why You Shouldn’t Cash in Your 401k

Taking cash out of your 401k is all too tempting when you’re trying to fund a business idea as an entrepreneur. It’s probably one of the largest assets you own that can be leveraged to start a business. Still, you have to resist the urge to do so.

Cashing out your 401k is dangerous and can sabotage the success of your business. Why? Here are 4 reasons why you don’t want to make the critical mistake of withdrawing funds from your 401k early.

1. Forfeiting future interest and savings.

Not only will you be giving up your entire savings amount, but you also forfeit any interest that would have accrued over time on those funds. Over the years, your savings will generate earnings on their own, and increase your 401k balance through compound interest.

If the market shoots up after you’ve withdrawn the funds, you’ll miss out on quite a large amount of revenue. The longer you keep the funds in the account, the more time they have to gain interest and increase your total savings.

2. Paying a 10% penalty.

Investors who are younger than 59 ½ and choose to withdraw funds from their 401k will have to pay a 10% early withdrawal penalty fee. A 2011 report from Bloomberg Businessweek found that Americans withdrew over $57 million from their retirement accounts before they were qualified to do so — which means the IRS earned $5.7 million dollars in early withdrawal penalty fees. Eeek!

You pay enough taxes every year, so don’t give away your hard-earned retirement savings to the IRS by cashing out your 401k account too early.

3. Incurring a large tax bill.

In addition to paying the 10% penalty, cashing out any funds from your 401k early will generate a large tax bill.

The plan administrator (who will be approving your withdrawal request and sending you the check) is required to withhold at least 20% of the balance. This figure is first sent to the IRS and put towards the taxes that have incurred, then the remaining balance is sent to you.

In other words, you won’t be receiving the entire balance because you’ll have to pay 20% straight to the IRS upfront, and another 10% penalty when you file your taxes at the end of the year. So if you withdraw $50,000 out of your 401k only $35,000 will be left for you to spend on starting a business.

4. Losing out on tax advantages.

One of the greatest advantages to having a 401k is that you can allocate a portion of your income into that account that won’t be subject to ordinary income tax. Yes, when you reach retirement later and withdraw the funds you’ll have to pay taxes then, but your tax rate could be much lower than it is now — during the peak of your income-generating career.

Additionally, you could qualify for various retirement and savers credits on your tax return (depending on your income bracket). So by withdrawing funds out of your 401k too early you’ll be losing out on some great tax advantages and deductions throughout your lifetime.

Why You Shouldn’t Cash Out Your 401k

The amount of interest and savings you’ll forfeit, mixed with the high tax liability and penalty, usually makes cashing out a 401k just not worth it. Of course, there are other options.

One way to avoid paying any additional taxes or penalties is to take a loan against your 401k. Just be aware that you’re required to pay yourself back, with interest. There are many other ways to find capital to start a business, and cashing out a 401k should be considered with caution.