- Cashing out a 401(k) plan should be considered a last resort.
- You can sometimes take a loan from your 401(k) instead of cashing it out.
- The IRS will charge you a 10% penalty for money taken out of your 401(k) early in most circumstances.
Having money saved for the future isn’t much help when you have bills due today. While most experts advise leaving your 401(k) fully funded until you can take the money out without penalty, there are times when it makes sense. But it’s something that should only be done as a last resort, as you’ll lose the potential compounding returns on your investments you’ll get by leaving it in place. In fact, before you go forward, input your current balance into an online calculator and look at just how much money you’ll have if you leave it in place.
If you do decide to cash out our 401(k) plan, you should know it requires a little planning. You’ll want to make sure you minimize tax penalties so that you get the most out of the money you’ve set aside. In this article, we’ll break down what you need to do to prepare for cashing out your 401(k), including determining eligibility and understanding what you’re giving up. As a result, you’ll be ready to make a fully-informed decision.
Eligibility for Cashing out a 401(k) Plan
No advice you receive on how to cash out 401(k) accounts will matter if your plan doesn’t allow it. Yes, some employers won’t let you take the money out. Even if your employer does, there could be restrictions on how the money can be withdrawn. You probably have some type of documentation with your 401(k) that you can check. If not, ask your HR department to provide your policy documents. You can always take money out of plans you’re not participating in anymore – e.g. a plan at an old employer.
If you’re 59 and ½ years old, though, none of that matters. You can take money from your 401(k) starting at age 59 and ½ without paying a penalty. If you haven’t yet celebrated your 59th birthday, you may prefer instead to take a loan against your 401(k) if your employer allows it. This will help get you through your financial situation while still ensuring the money is there when it’s time to retire.
If you do choose to take a loan against your 401(k), it’s important to know the risks. Although it will vary based on your employer’s restrictions, the maximum amount that can be borrowed against a 401(k) is usually 50 percent or $50,000, whichever is greater. Once you take out the money, you’ll have five years to pay it back, with interest that you’ll actually be paying into your own 401(k) account. Keep in mind that during this time, the money you’ve taken out will not be invested, so you’ll lose the compound interest you would have been earning. If you can’t pay it back, you’ll owe tax on that income, as well as a 10 percent penalty if you haven’t yet reached the minimum age.
It's important to note that the tax man may still come calling, even if you don’t pay a penalty. Traditional 401(k) plans are taxed when you take the money out, while Roth 401(k) accounts hold funds that you’ve already paid taxes on. If you have a Traditional 401(k), you’ll need to prepare to pay taxes on the money, whether you withdraw it at age 24 or 84. If you have a Roth 401(k), you can take your contributions out at any time since you’ve already paid taxes on them, but you’ll pay taxes on any earnings you withdraw early if you’re under 59 and ½.
No More Creditor Protection
Once you’ve squared away how long it takes to cash out your 401(k), it’s time to think about consequences. The first is the loss of protection against creditors. If you’re cashing out because creditors may come knocking, this is something you need to consider. Employer-sponsored 401(k) plans are often protected against creditors, bankruptcy proceedings, and civil lawsuits. Once you’ve cashed the funds out, they’ll be subject to action along with your other assets.
But before you assume this could be a problem, check to make sure your plan isn’t vulnerable for other reasons. If you’re in the process of divorcing or are already divorced, the other party could be able to snag a portion of the funds under a qualified domestic relations order. Funds in a 401(k) can also be seized to pay tax debts and federal penalties.
Penalties for Cashing Out Your 401(k) Early
Of course, the biggest consequence comes from the penalties you’ll pay. You already know you’ll likely have to pay taxes on your cash out. But if you take out the money before you reach 59.5 years of age, the IRS will charge a 10 percent early withdrawal penalty. The money will also be included with your gross income for the year and taxed at the rate that applies to your tax bracket. You could find that withdrawing the funds moves you into a higher tax bracket.
One way around this is to qualify for a 401(k) hardship withdrawal, which can exempt you from early withdrawal penalties. The following events can qualify you for a hardship exemption, depending on the rules laid out by your plan:
- Medical expenses
- Home purchase
- Tuition and related fees
- Eviction or foreclosure prevention
- Burial and funeral expenses
- Damage to your primary residence
In order to qualify, the need must be “immediate and heavy,” and it will be up to the employer’s discretion. If you’re in this situation, your employer will listen to your explanation and probably review the plan documents to decide whether to let you take money out or not.
How to Cash In Your 401(k)
If you want to liquidate your 401(k), you’ll usually start with your plan administrator. Again, check any documentation your HR department gave you when you set up your 401(k). There may also be a phone number on the statement you get on a periodic basis updating you on your balance.
What happens if you’re no longer with the employer? No worries. You’ll go through the same process of tracking down the plan administrator. But if your withdrawal request is due to a hardship, you will no longer have that benefit. You’ll only have three options: take a distribution, roll the balance over to an IRA, or leave the money in place.
How Long Does It Take To Cash In Your 401(k)?
Closing 401k accounts isn’t an overnight process, so you’ll need to get started early. You’ll first get in touch with the plan administrator and find out the requirements. If there’s a form to be filled out, the time to complete and submit it will factor into how long it takes. Once the administrator has the form, the law allows three business days for processing so that investments can be sold.
You still won’t have the money after those three days have passed, though. The processing time varies from one administrator to another.
The best thing you can do when closing out your 401k is to keep it in a retirement account. One way to do this is to roll the funds over to an IRA. IRAs have similar options to 401(k)s if you absolutely must move the money. By keeping your funds in a retirement account, you won’t have to pay taxes and you’ll still have the funds in place when you need them.
If you need emergency funds, you can withdraw the money and pay taxes on it during the year you take that money. By following the regulations under IRS Rule 72(t), you can withdraw funds out in a way that ensures you won’t even pay penalties.
Your 401(k) plan is there to help fund your retirement. But life happens. Although cashing out your 401(k) is always an option, it should only be used as a last resort. There are less costly alternatives that can help you get the money you need for those unexpected emergencies. Before doing anything, talk to a Certified Financial Planner who can walk you through all of your options.