What to Know Before Cashing Out Your 401(k)

What to Know and How to Cash Out Your 401(k)

Woman with cash in her hands
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Too many people cash in their 401(k) plan without fully understanding the consequences. This can be an expensive mistake, and there are some things you need to know before you take the cash.

Eligibility for Cashing a 401(k) Plan

If you are still employed by the company that sponsors your 401(k) plan, you won't be eligible to cash in your plan unless your plan offers a 401(k) plan loan, allows hardship withdrawals, or offers in-service withdrawals.

Try to avoid taking 401(k) loans. Most people are underfunded for retirement. Your money needs as much time as possible to grow. The loan also has to be paid back with interest so you're losing money in multiple ways.

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

If you choose to roll over your money instead of cashing in, you will not have to pay income 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 by the IRS. 

No More Creditor Protection

As long as your money's in a 401(k) plan it's creditor-protected, meaning that it's protected in the event of bankruptcy. It is unwise to cash in a 401(k) plan to pay down your debt if it is likely you may end up filing bankruptcy. The bankruptcy court cannot touch the money in 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 well-protected money meant for use in your retirement years.

You'll Owe Taxes and Possible Penalties

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, your plan will likely enforce a required 20 percent amount withheld from any balance that you cash in to cover federal taxes. So, for every $1,000 you cash in, you would receive about $800. The other $200 would be sent to the IRS by your 401(k) administrator. 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.

In general, you should not cash out your 401(k). Instead, roll it over into an IRA. When you calculate how much money you will lose by cashing out the account, the choice will become clear. Use an early withdrawal calculator to help you see how much a withdrawal will cost.

When you file your income tax return, you must include any cashed-out amounts from your 401(k) plan as regular income, along with your other sources of income. The amount flows into your tax return on the first page, and, based on your total income and deductions, you will either owe additional tax or receive 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 your employment no earlier than the year you turned 55. This is called the age of 55 401(k) withdrawal provision.

If you are over age 59 1/2, any amount you withdraw from your 401(k) plan will be subject to income taxes but no penalty taxes.

Know-How to Cash In

The first step to cashing in your 401(k) account is to call the phone number that appears on your 401(k) plan statement and ask them to send you the necessary paperwork to complete to cash in your 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 by hand.

Sometimes a signature from an HR employee or plan administrator from the firm at which you were employed 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.

When leaving your employer, be complimentary, positive, and grateful. Burning bridges will come back to haunt you when you need your ex-employer to complete paperwork for things like 401(k) withdrawals and rollovers. They have to do it but it probably won't be high on their priority list.

Receiving Your Money Takes Time

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

It can feel like your former employer is making it difficult for you to cash in your 401(k) plan, but there are strict rules your employer must follow, along with having all of the proper paperwork completed before they can distribute your money to you.