Your retirement fund is for retirement — but what if you need the money in your 401(k) now? After all, you earned it, right?
Not so fast.
The IRS lets you grow a portion of your income before the agency ever takes its cut — but only on the condition that you’ll save it for your golden years and not touch it until you’re at least 59½. The consequences of not holding up your end of the bargain are just what you’d expect from the IRS — severe and expensive.
Cashing Out is Only One of Five Options
Before you decide to cash out, it’s important to know your alternatives.
“If you have a 401(k) and you leave your employer, you have the following five options,” said Laura Adams, MBA, a personal finance expert with Finder.com:
- Cash it out
- Leave it with your ex-employer
- Roll it over to an individual retirement account (IRA)
- Roll it over to a 401(k) with a new employer
- If you have business income, roll it over to a self-employed account such as a solo 401(k) or SEP-IRA
If You’re 59 or Younger, the Other Four Choices Are Probably Better
The government gives special tax treatment to retirement accounts like 401(k)s to incentivize saving for retirement. If you pull from the account early, you lose the special treatment.
“Cashing out is the worst option for an old 401(k) because it’s an early withdrawal if you’re younger than 59½,” said Adams. “That means you’d have to pay income tax on amounts not previously taxed plus a hefty 10% penalty, leaving you with significantly less money.”
According to Forbes, the IRS typically withholds 20% for taxes. Together with the 10% penalty, that’s 30% — meaning you would get just $7,000 from a $10,000 early withdrawal.
In the long-term, the biggest loss could be future gains never realized.
“You no longer have that money invested,” said Carter Seuthe, CEO of Credit Summit. “And you won’t get any more returns on those investments.”
It’s not chump change.
According to Forbes, if you cash out $10,000 30 years before you retire, you miss out on $117,000 in total returns, according to historical market trends.
If There’s No Other Choice, Pursue a Hardship Exception
The right time to cash out a 401(k) is in retirement or the years leading up to it after you’ve reached the federal minimum age of 59½. That said, many people endure the financial beating associated with early cash-outs for one reason — they’re desperate for cash and there’s nowhere else to turn.“It should only be an option if you’re in a dire financial emergency, like a risk of foreclosure or bankruptcy,” said Melanie Hanson, editor in chief of EDI Refinance.
The good news is that the IRS exempts certain withdrawals from the 10% penalty in a handful of extraordinary circumstances “due to an immediate and heavy financial need,” according to the IRS’s page on hardship distributions. It’s important to note that you still have to pay income tax on any withdrawals you make, even if they qualify as hardship withdrawals and are exempt from the 10% penalty.
Recognized exceptions include:
- Total and permanent disability
- IRS levy
- Qualified medical expenses
- Distributions to qualified military reservists called to active duty
The Rule of 55
The IRS exempts people from the 10% penalty if they leave their jobs during or after the calendar year they turn 55. According to Forbes, some public service employees can apply the rule five years earlier on the calendar year they turn 50, but those are typically 403(b) accounts.
You have to wait until the minimum age whether or not you make a withdrawal. For example, if you leave work when you’re 54, but don’t touch your 401(k) until you turn 55, the rule doesn’t apply and you’ll be taxed and penalized like anyone else who cashes out early.
Some people utilize the Rule of 55 to facilitate early retirement. Others do it to minimize their required minimum distributions (RMDs). It can be a sound tactic, but keep in mind that the Rule of 55 does not apply to IRAs, and here, too, you still have to pay income tax on your withdrawal even if you avoid the 10% penalty.
Consider a 401(k) Loan as an Alternative
Fidelity cautions that you should explore all other options before tapping your 401(k) early, but if you must, a 401(k) loan might be better than a hardship withdrawal. If your employer’s plan allows it, a 401(k) loan lets you borrow money from your account and pay yourself back over time. You have to pay interest, same as any other loan — but you’re paying interest to yourself. Both the money you pay back and the interest go directly into your account and you avoid being penalized for early withdrawal.
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