Here's What to Know Before Cashing In Your 401(k)

Woman holding cash and coins in her hands.
After taxes and penalties, cashing in a 401(k) may not leave you with much. K. Miller Photographs / Moment / Getty Images

Too many people cash in their 401(k) plan without fully understanding the consequences. This can be an expensive mistake. Here's what you need to know before you take the cash.

Find out If You Are Eligible to Cash Out of Your 401(K) Plan

If you are still employed by the company that sponsors your 401(k) plan then you will not be eligible to cash out of the plan. Instead, to gain access to your money you can check to see if your plan offers either a 401(k) plan loan or allows hardship withdrawals.

If you are no longer employed by the company that sponsors your 401(k) plan, then you are eligible to get your money out. You can cash out of the plan or rollover your 401(k) plan balance to an IRA.

If you choose to rollover your money instead of cashing out, then, you will not have to pay taxes or penalty taxes because rollovers to IRAs are not taxable transactions if you do them the right way. Rolling over your 401(k) to another plan is not considered cashing it in.

Creditor Protection Is Lost

Money in a 401(k) plan is creditor protected and it is protected from bankruptcy. It is foolish to cash in a 401(k) plan to pay down debt if it is likely you may end up filing bankruptcy. The bankruptcy court cannot touch your 401(k) plan and creditors cannot attach liens against the assets in your 401(k) plan nor can they force you to withdraw this money to pay a debt. It is protected money for use in your retirement years.

Taxes Will Be Owed

If you cash in your 401(k) plan and you have not yet reached age 59 1/2, then the dollar amount you withdraw will be subject to ordinary income taxes and a 10% penalty tax.

If you are not yet age 59 1/2, it is usually required that 20% is withheld from any balance that you cash in for federal taxes, so for every $1,000 you cash in, you would receive about $800.

The other $200 would be sent to the IRS. At the end of the year, the 401(k) plan will send you a tax form called a 1099R that shows the amount of taxes withheld on your behalf.

When you file your tax return, you will include the amount of the 401(k) plan that is cashed in as income, along with other sources of income. It flows into your tax return on the first page and based on your total income and deductions, you will either owe additional tax or get a refund.

Your Age Matters

If you are between age 55 and 59 1/2 you may be able to avoid the 10% penalty tax if you terminated employment no earlier than the year you turned 55. I call this the age 55 401(k) withdrawal provision.

If you are over age 59 1/2 any amounts you withdraw from your 401(k) plan will be subject to income taxes, but not penalty taxes.

Know How to Cash Out

The first step is to call the phone number that appears on your 401(k) plan statement and ask them to send you the paperwork that you must complete to cash out of the plan. In some cases, you may be able to do this online or over the phone, but most of the time you must fill out paperwork.

Sometimes a signature from an HR person or plan administrator at the firm that you were employed by will be required.

If you worked for a smaller company you may have to take this paperwork to them or contact them yourself to get this done. If you worked for a large company this is often handled by the investment company that offers the investment choices inside the 401(k) plan.

Getting Your Money Takes Time

It typically takes several weeks to cash in your 401(k) plan. Some plans for smaller companies have the right to allow distributions only once a quarter or once a year. There is a 401(k) summary plan description document will spell out the rules for your plan. The plan must follow its own rules.

Sometimes it can feel like your former employer is making it difficult for you to get the money out of your 401(k) plan but there are strict rules your employer must follow and they must have all the proper paperwork to distribute your money.