Cashing Out 401ks

Cashing Out a 401(k): What a 401(k) Early Withdrawal Really Costs
A 10% penalty and a few other consequences could be headed your way. But there are many exceptions to the rules

Contributing to a 401(k) can be a “Catch 22” kind of experience: It’s easy to get your money in, but it’s hard to get your money out. That is, unless you’re at least 59½ years old — that’s when the door swings wide open for a 401(k) withdrawal. But try cashing out a 401(k) with an early withdrawal before that magical age and you could pay a steep price if you don’t proceed with caution.

Three consequences of a 401(k) early withdrawal or cashing out a 401(k)

Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401(k) early withdrawal for taxes. So if you withdraw the $10,000 in your 401(k) at age 40, you may get only about $8,000.
The IRS will penalize you. If you withdraw money from your 401(k) before you’re 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government $1,000 of that $10,000 withdrawal.
It may mean less money for your future. That may be especially true if the market is down when you make the early withdrawal. “If you’re pulling funds out, it can severely impact your ability to participate in a rebound, and then your entire retirement plan is offset,” says Adam Harding, a certified financial planner in Scottsdale, Arizona.
If you’re still thinking about cashing out a 401(k) or a 401(k) early withdrawal

1. See if you qualify for an exception to the 10% tax penalty

Generally, the IRS will waive it if any of these situations apply to you:

You choose to receive “substantially equal periodic” payments. Basically, you agree to take a series of equal payments (at least one per year) from your account. They begin after you stop working, continue for life (yours or yours and your beneficiary’s) and generally have to stay the same for at least five years or until you hit 59½ (whichever comes last). A lot of rules apply to this option, so be sure to check with a qualified financial advisor first.
You leave your job. This works only if it happens in the year you turn 55 or later (50 if you work in federal law enforcement, federal firefighting, customs, border protection or air traffic control).
You have to divvy up a 401(k) in a divorce. If the court’s qualified domestic relations order in your divorce requires cashing out a 401(k) to split with your ex, the withdrawal to do that might be penalty-free.
Other exceptions might get you out of the 10% penalty if you’re cashing out a 401(k) or making a 401(k) early withdrawal:

You become or are disabled.
You rolled the account over to another retirement plan (within a certain time).
Payments were made to your beneficiary or estate after you died.
You gave birth to a child or adopted a child during the year (up to $5,000 per account).
The money paid an IRS levy.
You were a victim of a disaster for which the IRS granted relief.
You overcontributed or were auto-enrolled in a 401(k) and want out (within certain time limits).
You were a military reservist called to active duty.
2. Check if you qualify for a hardship distribution

The IRS defines this as “an immediate and heavy financial need.” Generally, that includes:

Medical bills for you, your spouse or dependents.
Money to buy a house (but not to make mortgage payments).
College tuition, fees, and room and board for you, your spouse or your dependents.
Money to avoid foreclosure or eviction.
Funeral expenses.
Certain costs to repair damage to your home.
Your employer’s plan administrator usually decides if you qualify. You may need to explain why you can’t get the money elsewhere. You usually can withdraw your 401(k) contributions and maybe any matching contributions your employer has made, but not normally the gains on the contributions. Check your plan. You may have to pay income taxes on a hardship distribution, and you may be subject to the 10% penalty mentioned above.

3. Consider converting your 401(k) to an IRA

Individual retirement accounts have slightly different withdrawal rules from 401(k)s. So, you might be able to avoid that 10% 401(k) early withdrawal penalty by converting your 401(k) to an IRA first. (Be sure that you understand the investment and fee differences between 401(k)s and IRAs, of course.) For example:

There’s no mandatory withholding on IRA withdrawals. That means you might be able to choose to have no income tax withheld and thus get a bigger check now. (You still have to pay the tax when you file your return, though.) So if you’re in a desperate situation, rolling the money into an IRA and then taking the full amount out of the IRA might be a way to get 100% of the distribution. This strategy may be valuable for people in low tax brackets or who know they’re getting refunds. (See what tax bracket you’re in here.)
You can take out up to $10,000 for a first-time home purchase. Rolling a 401(k) into an IRA may also be a way to finagle cashing out a 401(k) without having to pay the 10% penalty.
School costs could qualify. Withdrawals for college expenses could be OK if they fit the IRS’ definition of “qualified higher education expenses.”
4. Take out the bare minimum when cashing out a 401(k)

“Anytime you take early withdrawals from your 401(k), you’ll have two primary costs — taxes and/or penalties — which will be pretty well-defined based on your age and income tax rates, and the forgone investment experience you could have enjoyed if your funds remained invested in the 401(k). This total cost should be considered in detail before making early withdrawals,” Harding says.

Don’t make a 401(k) early withdrawal just to pay off debt or buy a car; early withdrawals from a 401(k) should be only for true emergencies, he says. Even if you manage to avoid the 10% penalty, you probably will still have to pay income taxes when cashing out 401(k)s. Plus, you could stunt your retirement. “If you need $10,000, don’t make it $15,000 just in case,” Harding says. “You can’t get it back in once it’s out.”

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