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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

Cash out your 401(k) early? Good idea!

Dear Dollar Diva,
I contribute 3 percent of my income to my company's 401(k) plan; the company matches the 3 percent, and I'm 100 percent vested. I'm going to college to become a teacher, and will have to quit my current job in two years to student teach for a semester. I plan to live on my 401(k) money while I student teach for five months, but have been told I will lose about 40 percent of my money to taxes. Should I keep contributing to the plan, or invest the money somewhere else?
Tim

Dear Tim,
As a rule, you shouldn't use a 401(k) plan as a short-term savings vehicle, but rules are made to be broken, and your strategy is sound; even though you'll have to pay income tax and that nasty 10-percent early withdrawal penalty.

Here's why:

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  • Your employer match is giving you a 100-percent return the second you contribute. That more than compensates for the 10 percent early withdrawal penalty.
  • 401(k) contributions are tax-deferred, not tax-free. You don't pay tax when you make the contribution; you pay it when you take the distribution, even if it's not an early distribution subject to the 10-percent penalty. The deferred tax accounts for most of the 40 percent you've heard about. Let's pretend you're in the 27 percent tax bracket: Because of the tax deferral, a $100 contribution to your 401(k) plan only costs $73. It wouldn't hurt to set aside the $27 tax savings, since you know Uncle Sam will be looking for it in two years.
  • You won't be drawing a salary while you're student teaching, so the 401(k) distribution is not likely to kick you into a higher tax bracket. If it does, the employer match would compensate, so it shouldn't change your plan. The Diva writes about the dangers of slapping a big chunk of income on your tax return in "4 good reasons for not tapping your IRA."

When the employer contributes, even if you don't
If you have one of those nice employers who contributes even if you don't, you need to rethink your strategy:

  • Contribute to the 401(k) plan if your current tax rate is 27 percent, but you expect to be in the 15 percent bracket the year you student teach. The tax savings will more than compensate for the 10 percent penalty.
  • Do not contribute to the 401(k) plan if you expect your tax rate to be the same or higher when you take the distribution. Save your money outside the plan.

Where to stash the cash
Whether you save in your 401(k) plan or outside it, your time horizon is short; preservation of capital is your primary goal.

You cannot invest in anything that depends on the market for its value; forget about stocks and most bonds. Your cash needs to be stashed in money market mutual funds, certificates of deposit or U.S. savings bonds.

The Diva writes about investing for safety, liquidity and the best rate in "Where to open an emergency fund account" and "Where do I stash my emergency cash?"

-- Posted: Feb. 14, 2002

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See Also
Frequently asked questions about 401(k)s
401(k)s for beginning investors
More Dollar Diva columns
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