Take Distributions From The Old 401
After youve reached 59½, you may withdraw funds from your 401 without paying a 10% penalty.
You may have decided to retire and are considering withdrawing funds from your account. If youre retiring, it may be a good time to start drawing on your savings for income. Youll have to pay tax at your regular rate on any distributions you take out of a traditional 401. Annuities are a reliable tool for spending your 401 without running out of money.
If you have a designated Roth 401, any payments you take after 59 1/2 are tax-free if youve held the account for at least five years. Only the earnings portion of your distributions is taxed if you do not fulfill the five-year requirement.
When you reach age 72, you must begin taking RMDs from your 401 if you leave your employment. The amount of your RMD is determined by your expected life span and 401 account balance.
Can You Withdraw Money From Your 401k Before Or During Your Bankruptcy
There are certain things a debtor should not do before filing bankruptcy.
I will occasionally have a bankruptcy client ask me if she should withdraw money from her 401k before filing bankruptcy. I also have received questions about whether it is ok to take out of a 401k after filing bankruptcy. My answer is always that is a bad idea, but the reasoning as it pertains to a Chapter 7 or Chapter 13 bankruptcy is slightly different, so I will now tackle each one separately.
There are two reasons why it is a bad idea to withdraw from a 401k before filing bankruptcy. The first one is not specific to bankruptcy, but rather to general retirement and tax planning. The penalties associated with an early 401k withdrawal, plus the reduction in your retirement savings, truly make this an option of last resort.
Therefore, the only time I could endorse this strategy in any way is if the debtor is using the money to pay off creditors and avoid filing bankruptcy. I basically would never endorse a 401k withdrawal if it doesnt resolve the debt situation.
The second factor in withdrawing from a 401k prior to bankruptcy is the impact on the bankruptcy itself. Money saved in a 401k is exempt in bankruptcy and cannot be taken by the bankruptcy trustee. However, when it is converted into cash before filing bankruptcy, it loses its exempt status and becomes a non-exempt asset in the form of cash.
What Happens To Your 401k When You Sell Shares
Youll be free to sell the shares the day after you transfer them out of your 401 , and pay only the current capital gains rate on the NUA, rather than the income tax rate youd pay were they held in an IRA. One caveat, though: This break does not apply to any further appreciation in the stock after it is transferred out of your 401 .
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Disadvantages Of Closing Your 401k
Whether you should cash out your 401k before turning 59 ½ is another story. The biggest disadvantage is the penalty the IRS applies on early withdrawals.
First, you must pay an immediate 10% penalty on the amount withdrawn. Later, you must include the amount withdrawn as income when you file taxes. Even further down the road, there is severe damage on the long-term earning potential of your 401k account.
So, lets say at age 40, you have $50,000 in your 401k and decide you want to cash out $25,000 of it. For starters, the 10% early withdrawal penalty of $2,500 means you only get $22,500.
Later, the $25,000 is added to your taxable income for that year. If you were single and making $75,000, you would be in the 22% tax bracket. Add $25,000 to that and now youre being taxed on $100,000 income, which means youre in the 24% tax bracket. That means youre paying an extra $6,000 in taxes.
So, youre net for early withdrawal is just $16,500. In other words, it cost you $8,500 to withdraw $25,000.
Beyond that, you reduced the earning potential of your 401k account by $25,000. Measured over 25 years, the cost to your bottom line would be around $100,000. That is an even bigger disadvantage.
Rolling 401k Into Ira
When you leave an employer, you have several options for what to do with your 401k, including rolling it over into an IRA account.
Its possible to do the same thing while still working for an employer, but only if the rules governing your workplace 401k allow for it.
The negative for rolling the money into an IRA is that you cant borrow from a traditional IRA account.
Another option when you leave an employer is to simply leave the 401k account where it is until you are ready to retire. You also could transfer your old 401k into your new employers retirement account.
If you are at least 59 ½ years old, you could take a lump-sum distribution without penalty, but there would be income tax consequences.
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How Much Are You Penalized For Early Withdrawal Of 401k
As of 2021, if you are under the age of 59½, a withdrawal from a 401 is subject to a 10% early withdrawal penalty. You will also be required to pay normal income taxes on the withdrawn funds. 1 For a $10,000 withdrawal, when all taxes and penalties are paid, you will only receive approximately $6,300.
So What Should You Do
First off, I need to disclose again that I am neither an accredited financial advisor nor a CPA. I just love this stuff. While I am sure there are many ways to creatively use your retirement funds, I am sharing with you what I have learned and what seems to me are the most plausible scenarios.
The most optimal way to use your 401k is to either move it into a self-directed IRA/solo 401k or to take a loan out against the funds to help you invest in real estate. Which of those scenarios to choose is entirely up to you and dependent on your goals.
If your goals are to accumulate maximum net worth, then the self-directed account makes the most sense. Invest the solo 401k/self-directed IRA in real estate tax-deferred. This way, you can experience both the phenomenal long-term returns of real estate as well as tax-deferred growth.
If your goals are to attain early financial freedom and you dont care much about the returns of the 401k, it makes more sense to take the loan out against your 401k, use the proceeds from the loan to assist with your down payment, and pay your retirement account a relatively low interest rate of ~4%. Depending on the balance of your 401k, this will free up to $50,000 for you, which will be more than enough to get started on a house hack.
Whats your strategy of choice when it comes to the 401kand why?
Id love to hear from you in the comments!
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Consider Taking Out A 401k Loan Rather Than Withdrawing
To avoid early withdrawal fees, consider taking out a 401k loan. A 401k loan is money borrowed from your retirement fund. This loan charges interest payments that are essentially paid back to your future self. While some interest payments are put back in your account, your opportunity for compounding interest may slightly decrease. Compounding interest is interest earned on your principal balance and accumulated interest from past periods. While you may pay a small amount in interest fees, this option may help you avoid the 10 percent penalty fee.
As your retirement account grows, so does your interest earned thats why time is so valuable. While taking out a 401k loan may be a better option than withdrawing from your 401k, you may lose out on a small portion of compounding interest. When, or if, you choose to take out a 401k loan, you may start making monthly payments right away. This allows your payments to grow interest and work for you sooner than withdrawing from your 401k.
This type of loan may vary on principle balance, interest rate, term length, and other conditions. In most cases, youre allowed to borrow up to $50,000 or half of your account balance. Some accounts may also have a minimum loan balance. This means youll have to take out a certain amount to qualify. Interest rates on these loans generally charge market value rates, similar to commercial banks.
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Reasons To Proceed With Caution
Experts suggest moving slowly with any withdrawal. Here are three things to consider.
Hardship withdrawals are still subject to income taxes. Since your savings went into your retirement plan on a pretax basis, you’ll be paying income taxes on the contributions and earnings withdrawn.
“You get a three-year period to pay the taxes to Uncle Sam,” said Paul Porretta, partner at Pepper Hamilton LLP in New York.
Plan ahead to cover the tax bill and spread it over that period of time, perhaps out of your cash flow.
Know your 401 plan’s rules. Be aware that a workplace retirement plan may allow hardship distributions from participants’ savings, but it isn’t required to do so.
You’ll need to talk to your human resources department or your plan administrator before you proceed.
“A 401 plan or a 403 plan, even if it allows for hardship withdrawals, can require that the employee exhaust other sources of money before taking a withdrawal,” said Porretta.
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Build An Emergency Fund
This should be the foundation of your financial plan and experts recommend having about six months worth of expenses saved. You can park this money in a high-yield savings account to earn more interest than you would in a traditional checking account. An emergency fund should help you manage most of lifes curveballs.
What Are The Penalties For Withdrawing 401 Funds Early
The IRS generously allows you to contribute to your 401 with pre-tax money. Meaning you can put money into your 401 without paying taxes first. Youâll owe taxes on distributions you take during retirement. However, your contributions and growth will be tax-free.
On the other hand, withdraw your money too soon, and the IRS hits you with a 10% penalty tax for any amount you take out. This is on top of the income tax youâll be required to pay.
In some circumstances, the IRS will waive this 10% penalty if you meet specific criteria. This makes liquidating your 401 easier and penalty-free.
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Withdrawing When You Retire
After you reach the age of 59 1/2, you may begin taking withdrawals from your 401. If you leave your job in the calendar year when you turn 55 or later, you can also begin taking penalty-free withdrawals from the 401 you had with that current company. If you are a public safety worker, this rule takes effect at the age of 50.
Once you reach 72, you are actually obligated to begin making required minimum distributions or RMDs.
Receiving Your Money Takes Time
It often takes several weeks to cash out a 401 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 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 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.
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The High Cost Of Hardship Withdrawals
So what’s the best way to have money for unexpected expenses? Build an emergency fund. You can tap into that without incurring early withdrawal penalties.
Generally, you should have enough cash to cover three to six months of living expenses in case of an emergency, like being laid off from work.
If saving that much money seems daunting, start small. Aim to build a fund of at least $500 and go from there. Be sure to build your savings back up when you take money out of the account. Don’t forget to take advantage of the power of compound interest.
The Costs Of Early 401k Withdrawals
Early withdrawals from an IRA or 401k account can be an expensive proposition because of the hefty penalties they carry under many circumstances.
The IRS allows penalty-free withdrawals from retirement accounts after age 59 ½ and requires withdrawals after age 72 . There are some exceptions to these rules for 401ks and other qualified plans.
Try to think of your retirement savings accounts like a pension. People working towards a pension tend to forget about it until they retire. There is no way they can access it before retirement. While that money is locked up until later in life, it becomes a hugely powerful resource in retirement. The 401k can be a boon to your retirement plan. It gives you flexibility to change jobs without losing your savings. But that all starts to fall apart if you use it like a bank account in the years preceding retirement. Your best bet is usually to consciously avoid tapping any retirement money until youve at least reached the age of 59 ½.
If youre not sure you should take a withdrawal, you can use this calculator to determine how much other people your age have saved.
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How To Make An Early Withdrawal From A 401
When you have determined your eligibility and the type of withdrawal you want to make, you will need to fill out the necessary paperwork and provide the requested documents. The paperwork and documents will vary depending on your employer and the reason for the withdrawal, but when all the paperwork has been submitted, you will receive a check for the requested funds, hopefully without having to pay the 10% penalty.
Withdrawing Funds Between Ages 55 And 59 1/2
Most 401 plans allow for penalty-free withdrawals starting at age 55. You must have left your job no earlier than the year in which you turn age 55 to use this option. You must leave your funds in the 401 plan to access them penalty-free, but there are a few exceptions to this rule. This option makes funds accessible as early as age 50 for many police officers, firefighters, and EMTs.
Make sure to understand the rules around the age requirement for penalty-free withdrawals. For example, the age 55 rule wont apply if you retire in the year before you reach age 55, and your withdrawal would be subject to a 10% early withdrawal penalty tax in that case.
The age-55-and-up retirement rule wont apply if you roll your 401 plan over to an IRA. The earliest age to withdraw funds from a traditional IRA account without a penalty tax is 59 1/2.
You might retire at age 54, thinking that you can access funds penalty-free in one year, but doesnt work that way. You must wait one more year to retire for this age rule to take effect.
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Withdrawing From A 401 After Leaving The Company Without A Penalty
In any of the following situations, you may qualify for early withdrawal without being subjected to any penalty:
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If you leave a company the same year you turn 55 years old
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If you suffer from total or permanent disability
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If you cash out in equal installments spread over an expected period of your remaining lifetime
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If you need to pay for medical expenses, which are more than 10% of your income
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If as a military reservist, you have been called to active duty
When A Problem Occurs
The vast majority of 401 plans operate fairly, efficiently and in a manner that satisfies everyone involved. But problems can arise. The Department of Labor lists signs that might alert you to potential problems with your plan including:
- consistently late or irregular account statements
- late or irregular investment of your contributions
- inaccurate account balance
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Can You Make An Early Withdrawal From Your 401 Plan
Yes, you can make an early withdrawal but just because you can, it doesnt mean that you should. Cashing out from your 401 plan early can come with several financial consequences such as loss of interest growth or penalties. This is why its not recommended to cash out the 401 until you are at least 59 years old.
What Is The Best Thing To Do With My 401k When I Retire
Consolidating your retirement accounts by rolling your savings into a single IRA can simplify your financial life. If you plan to take on another job in retirement, you could also move your money into your new employer plan. … If you are in financial trouble, it is best to leave your money in a 401 plan.
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How Do I Transfer An Old 401 To My New Job
Even if youre happy at your job, its always a good idea to keep your options open. If youre considering a move to a new company, one of the first things youll need to do is figure out what to do with your old 401. Fortunately, transferring an old 401 to your new job is usually a pretty straightforward process.
So, if youre planning a job change, dont forget to take care of your retirement savings. With a little effort, you can ensure that your hard-earned money stays right where it belongs in your pocket.
