Too many people cash out their 401(k) plans without fully understanding the consequences. That can be an expensive mistake, and there are some things you need to know before you take the cash.
- If you have a 401(k) and are still employed with your company, you can't "cash out" your account; you may be able to if you no longer work there, however.
- Cashing out your account before retirement age can lead to many penalties and tax implications.
- If you decide to move forward, call your retirement company, fill out the paperwork, and be aware that you won't receive the money immediately.
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 out your plan unless it 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'd be losing money in multiple ways.
If you're no longer employed by the company that sponsors your 401(k) plan, then you are eligible to receive your money. You can cash out the plan or roll over your 401(k) plan balance to an IRA.
If you choose to roll your money over instead of cashing out, 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 your 401(k) over to another plan is not considered cashing it out by the IRS.
No More Creditor Protection
As long as your money is in a 401(k) plan, it's creditor protected, meaning it's shielded in the event of bankruptcy. It is unwise to cash out a 401(k) plan to pay down your debt if it is likely you will end up filing bankruptcy. The bankruptcy court can't touch the money in your 401(k) plan, and creditors can't attach liens against its assets, 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 out 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% amount withheld from any balance you cash out to cover federal taxes. So for every $1,000 you cash out, 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 tax form 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 would 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 you.
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 ages 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 Out
The first step toward cashing out 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 you need to complete to cash out your plan. In some cases, you may be able to do that 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 such as 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 out a 401(k) plan. Some plans for smaller companies have the right to allow account distributions only once per quarter or once per 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 as though your former employer is making it difficult for you to cash out your 401(k) plan, but there are strict rules they must follow, along with having all of the proper paperwork completed before they can distribute your money to you.