How to Cash Out Your 401(k)


If you withdraw money from your 401(k) before age 59 1/2, you'll miss out on a lot of money down the road.
If you withdraw money from your 401(k) before age 59 1/2, you'll miss out on a lot of money down the road.
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Since 1982, American workers have been saving for retirement by contributing to 401(k) plans. A type of defined contribution plan offered by many employers, a traditional 401(k) allows an employee to elect for his employer to contribute up to 15 percent of his monthly pay to the plan. Some employers will match the amount set aside up to a certain amount. The employee then chooses from a number of funds -- including various money market, mutual and bond funds -- in which the money is invested.

The employee will ultimately receive the balance in the account, which fluctuates based on changes in the value of the investments, as well as the amount of contributions to the account. The employee is not taxed on the money in the plan until it's withdrawn. Additionally, 401(k) money is protected in the event the company sponsoring the plan goes bankrupt, although some plans require the employee to be enrolled for a certain amount of time before the portion of employer contributions to the balance are protected [sources: Department of Labor, Employee Retirement Income Security Act of 1974].

About 60 percent of households nearing retirement age have 401(k)-type accounts, and as the national economy continues to sputter, many are turning to this portion of their nest egg for help. While the money in a 401(k) account ultimately belongs to account holder, cashing out a 401(k) early can have dire affect on a person's financial security [source: Browning].

Here are some things you should know before cashing out your 401(k).

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].

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Penalties for Cashing Out Your 401(k) Early

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:

  • distributions to an employee who is 55 or older and no longer works for the employer sponsoring the plan
  • distributions to pay a domestic relations order such as child support or alimony
  • distributions to pay off tax debt (i.e. unpaid income tax)

[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].

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Borrowing From and Rolling Over Your 401(k)

Some 401(k) plans allow you to borrow money from your fund, which you repay to yourself, not a bank!
Some 401(k) plans allow you to borrow money from your fund, which you repay to yourself, not a bank!
©iStockphoto.com/Night and Day Images

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.

Finance Planning Tips

Here are some tips to help you with generating income and planning for the future.

Presented by United Way of Greater Atlanta Powered by SunTrust Foundation

Related Articles

More Great Links

Sources

  • Browning, E.S. "Retiring Boomers Find 401(k) Plans Fall Short." The Wall Street Journal. Feb. 19, 2011. (May 16, 2011)http://online.wsj.com/article/SB10001424052748703959604576152792748707356.html?mod=WSJ_hp_MIDDLENexttoWhatsNewsTop
  • CNN. "401(k)s: Top Things to Know." (May 16, 2011)http://money.cnn.com/magazines/moneymag/money101/lesson23/index.htm
  • Rooney, Ben. "Unemployed tap their 401(k)s." CNN Money. Oct. 28, 2009. (May 24, 2011)http://money.cnn.com/2009/10/28/pf/hewitt_401k/index.htm
  • U.S. Department of Justice. "Employee Retirement Income Security Act of 1974 (ERISA) -28 U.S.C. 1001." (May 16, 2011)http://www.justice.gov/usao/eousa/foia_reading_room/usam/title9/135mcrm.htm
  • U.S. Department of Labor. "Retirement Plans, Benefits & Savings: Types of Retirement Plans." (May 16, 2011)http://www.dol.gov/dol/topic/retirement/typesofplans.htm
  • U.S. Internal Revenue Service. "401(k) Resource Guide - Plan Participants - General Distribution Rules." May 5, 2011. (May 16, 2011)http://www.irs.gov/retirement/participant/article/0,,id=151787,00.html
  • U.S. Internal Revenue Service. "Publication 590 (2010), Individual Retirement Arrangements (IRAs)." (May 16, 2011).http://www.irs.gov/publications/p590/index.html
  • U.S. Internal Revenue Service. "Retirement Plans FAQs regarding Hardship Distributions." Nov. 17, 2010. (May 16, 2011) http://www.irs.gov/retirement/article/0,,id=162416,00.html

Finance Planning Tips

Here are some tips to help you with generating income and planning for the future.

Presented by United Way of Greater Atlanta Powered by SunTrust Foundation