Cashing Out Your 401(k)

Despite the often hefty penalties involved, many Americans are digging into their 401(k) plans early. Roughly 46 percent of people changing or losing their jobs in 2008 took money out of their 401(k) accounts, and the less a person has saved in a 401(k), the more likely he is to tap the account. Only 8 percent of workers with 401(k) balances of $100,000 or more cashed out their plans in 2008, while 85 percent of workers with a balance of $1,000 or less took a cash distribution [source: Rooney].

To cash out all or part of a 401(k) fund without being penalized, a person must reach the age of 59 1/2, die, become disabled or -- under some plans -- suffer a "financial hardship." Penalty-free withdrawals are also available when an employer discontinues the 401(k) plan without establishing a new defined contribution plan. These distributions are taxable as income and may be subject to an additional tax on early distributions of elective contributions [source: IRS].

A person's eligibility for a financial hardship distribution is determined by the terms of the specific 401(k) plan. Additionally, IRS regulations require that the early withdrawal request "must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need." This includes needs of the employee's spouse or dependant. Examples of "immediate and heavy" financial needs that may be eligible for an early withdrawal include certain medical expenses, tuition and related educational fees and costs related to the purchase or repair of a principal residence, as well as payments necessary to avoid eviction. 401(k) plans that allow for hardship distributions typically specify the information that must be provided to the employer to demonstrate a hardship. The amount of the distribution cannot be more than the amount that the employee has contributed under the plan [source: IRS].