How to Cash 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].

For employees who are not yet eligible to withdraw money from their 401(k) (and some who take hardship distributions), if you want your money early, you're going to pay for it. All early withdrawals from a 401(k) plan are subject to a 10 percent excise tax. However, as in all aspects in life, there are exceptions to this rule. Distributions not subject to the excise tax include:

[source: IRS]

Yet it's not just through tax penalties that an early 401(k) cash-out can wreak havoc on retirement savings. There is also the standard income tax implication. An employed person who raids his 401(k) early is likely to be in a higher tax bracket at the time of the withdrawal than a retired person who withdraws the same amount of money, simply because the retired person is likely to have less income. Additionally, by reducing the amount of money in the 401(k) account, the account holder lessens the amount of interest he can earn on the money.

Given the current state of the economy, someone who taps into his 401(k) earlier will likely have to work longer before retirement than those who hold off. A 2011 study indicates that the median household headed by a person age 60 to 62 with a 401(k) account -- many of which lost up to one-third of their value when stocks tanked starting in 2008 -- has less than one-quarter of what is needed in that account to maintain its standard of living in retirement. That includes people who have not yet withdrawn funds from their 401(k) [source: Browning].

Cashing out isn't the only way for those who need it to get money out a 401(k). Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The benefit of this type of loan is that the borrower repays himself -- by eventually putting the borrowed money back into the 401(k) -- rather than a bank.

If loans are permitted under terms of the 401(k) plan, the employee may borrow up to 50 percent of the vested account balance up to a maximum of $50,000 without the money being taxed. The borrower must repay the loan within five years unless the loan is used to buy a primary residence, and loan repayments must be made at least quarterly in substantially level amounts. If the borrower defaults on the loan, the money becomes a taxable distribution with all the same tax penalties and implications of a withdrawal.

401(k) account holders should also be aware of their options when changing jobs. A person who leaves one job for another can either keep his existing 401(k) money where it is or move it to another account. If the new employer doesn't offer a 401(k), the employee can move the money into an IRA. Money "rolled over" to a new account is not taxable until withdrawn. If the money to be rolled over is paid directly to the account holder (i.e. your former employer writes you a check for the amount in your 401(k)), the money must be transferred to a new 401(k) or IRA within 60 days. Since any taxable distribution paid directly to the account holder is subject to mandatory withholding of 20 percent, even if the person intends to roll it over, an employee seeking to roll over funds from a previous 401(k) should ask that the money be transferred directly to the new plan or IRA.

401(K) holders looking for extra cash should keep all these options in mind when considering whether to tap into retirement savings early. Other savings tools (particularly IRAs) may also provide penalty-free ways to get at money, depending on the holder's circumstances. For more information on 401(k)s and retirement savings strategies, check out the related articles and links on the next page.