A record number of Americans raided their 401(k)s to cover an emergency in 2023, says Vanguard — but here’s how looting your account can cost far more than you’d think

The hidden cost of early withdrawals

A 401(k) is meant to be a retirement savings vehicle, allowing your money to grow tax-deferred and compound over time. But life happens, and in times of financial strain, some people consider withdrawing funds early. While hardship withdrawals are allowed for medical expenses, they still come at a cost.

Take a $5,000 withdrawal, for example. If that money had stayed invested, it could have grown to approximately $5,724 over two years, assuming a modest 7% annual return. Instead, withdrawing early means losing out on that growth and getting hit with penalties. If you’re under 59½, you'll likely owe a 10% penalty ($500) plus income tax at a 22% rate ($1,100), leaving you with just $3,400 in hand.

But if you leave that initial $5,000 invested for 20 years, you’d end up with a total of $19,348 saved. And the longer you keep your money invested, the more it compounds. Even if you plan to repay the amount later, missing out on compounding returns can leave a lasting dent in your retirement savings.

Before tapping into your 401(k), it’s worth exploring other options to cover medical expenses without sacrificing your future financial security.

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Explore other options

Even though withdrawing from your 401(k) can leave you with missed opportunities for financial growth, there are ways to prepare yourself in advance for emergencies, so you can have some wiggle room without needing to dip into your long-term investments.

One way to do this is by setting up an emergency fund, where you allocate a portion of your paycheck each month. Even small, consistent contributions can add up over time, providing you with a buffer for unplanned expenses.

You might also consider using a high-yield savings account for keeping your emergency fund, as it allows your money to grow at a competitive rate while still remaining accessible.

While the national average saving account rate is 0.41%, a high-yield savings account could offer returns closer to 4%. This means that instead of your money sitting idle, it earns a modest return, helping your emergency fund keep pace with inflation and maintain its purchasing power over time.

If you're unsure whether to withdraw from your 401(k) or explore other savings options, it might be best to https://moneywise.com/managing-money/retirement-planning/how-to-retire-earlyenlist the help of a financial adviser. A financial professional can help you assess your choices and determine the best fit for your financial goals.