A 401k plan is designed for long-term investment. Typically, you’ll want to leave money in your 401k until you’ve reached retirement age. But, there are times when you might need to cash in your 401k sooner.
Before you embark on any course of action, you should understand 401k limits on withdrawals, the tax and penalty ramifications and the damage you might be doing to your retirement savings. Generally, you have two options: You can either roll over the money to another account, or you can take the money out.
Here’s what else you need to know about withdrawing from your 401k.
6 Things to Know Before Cashing Out a 401k
A 401k is a tax-deferred account, meaning the IRS enforces several restrictions regarding access to the funds inside. Usually, there’s a way to get the money if you really need it, but it can involve some unpleasant consequences. Here’s what to know before cashing out a 401k:
1. Age Requirements and Penalties
The easiest way to enjoy a penalty-free withdrawal from your 401k is to reach “retirement age.” Once you’re over 59.5, you can take money out of your 401k without paying the IRS-imposed 10 percent penalty for early withdrawals. You can also take a penalty-free withdrawal if you’ve “separated from service” — meaning you’ve quit, retired or otherwise left your job — and are at least age 55.
2. Premature Withdrawal Exceptions
The IRS does allow for the penalty-free withdrawal of money from a 401k in certain special circumstances, including the following:
- You die, in which case beneficiaries can withdraw money penalty-free.
- You become disabled.
- You take “substantially equal periodic withdrawals” after separating from service.
- You are required to take out money due to a qualified domestic relations order, or QDRO.
- You take out money for certain medical expenses exceeding 7.5 percent of your adjusted gross income.
- You take out money due to an IRS levy.
- You withdraw money as a qualified military reservist.
- You take distributions of dividends from an employee stock ownership plan.
With a traditional 401k plan, the money you contribute goes in pre-tax and your earnings are not taxed if the money remains in the account. So when you take a withdrawal from your 401k, all the money that comes out is taxable at ordinary income tax rates. The only exception to this is if you put in money after tax, which requires the permission of your 401k plan, or if you contribute to a Roth 401k.
4. Time to Get Money
Liquidating a 401k balance is not the same as making a simple trade on the stock exchange. Your 401k plan administrator will need time to sell your investments and process your distribution. This can occur as rapidly as one business day, but you should anticipate that it might take seven to 10 days before you receive your funds.
5. Impaired Retirement Savings
A 401k plan is the easiest way for most Americans to save for retirement. Contributions can be automatically deducted from your paycheck, your employer might offer a match of some of your contributions, and your money grows tax-deferred until you withdraw it. Taking the money out of your 401k might leave you struggling to reach your retirement savings goals unless you have significant outside assets.
6. Rollover Option
Leaving your job for any reason gives you the option of rolling over your money into another tax-deferred account. For example, if you have a new job and your employer offers a 401k, you can roll over your account from your former employer’s plan to your new employer’s plan. Another option is to roll the money over to an IRA. In both cases, your money will continue to grow tax-deferred until you withdraw it, and there are no taxes or penalties involved in the transfer.
Learn More: Benefits of a 401k Rollover
Consider the Consequences of Cashing Out Your 401k
The traditional way to move money out of your 401k is to roll it over to another tax-deferred account. If you absolutely need to take out the cash, learn about the penalties you’ll incur and the taxes you’ll owe before you make a move. And be aware of the effects a 401k withdrawal could have on your retirement planning.