Cashing Out Your 401k By Taking An Early Distribution
There are times when youre allowed to cash out your 401k early even without a hardship, but not very many of them.
Basically, the main reasons you can cash out your 401k early are if:
- you are no longer employed by the company your plan is at
- the 401k plan itself ends
- you have a QDRO
- you meet the rules for a coronavirus-related distribution and your plan allows it
For example, if you have a 401k at an old employer or are leaving your job, you can ask them to send you a check for the balance. It will normally be subject to a mandatory 20% tax withholding if you do that.
Another example is thanks to the CARES Act. With that, you can take a penalty-free 401k withdrawal of up to $100,000 on or after January 1, 2020 and before December 31, 2020 if you qualify. This is more than the usual amount allowed, and it will count as taxable income over the next 3 years unless you choose to have it count all at once. With this type of withdrawal, you are allowed to repay it if you can. In general, you qualify if you, your spouse, or dependent are diagnosed with SARS-CoV-2 or COVID-19, if youre having money troubles due to the virus, and if your plan allows it. Youll have to certify that you qualify to your plan.
But no matter how you do it, cashing out your 401k early instead of rolling it over usually has some pretty big downsides. Well cover those in the next section, and go over some of the cons for hardship withdrawals at the same time.
Should I Take Money Out Of My Ira To Pay Off Debt
11 Minute Read | December 14, 2021
If youre in the middle of paying off your credit cards, car loans or student loans, you know that every extra dollar toward debt helps. But if youre starting to consider your retirement fund as a way to dig yourself out of the hole, hold up!
While it may be tempting, taking money out of an IRA to pay off debt is a terrible idea. Not only can that money come with outrageous early withdrawal penalties and taxes, but its also stealing from your future self. Weve broken down what happens when you cash out a retirement fund early, and well tell you how you can pay off debt without raiding your IRA.
What Does Tax Advantaged Mean
Tax-advantaged means the fund is subjected to different tax rules that generally are geared in favor of the investor. Taking advantage of these types of accounts means you can usually save and invest more money by either deferring taxes or being exempt from taxes .
There are two main tax-advantaged 401k plans:
- A Roth 401k
- A Traditional 401k
How A Tax-Deferred 401k Works
A traditional 401k defers taxes until you draw money out of the account. In simple terms, your employer will take money from your paycheck and invest it in your traditional 401k before any taxes are paid to the government.
For example, if you make $5,000 a month and invest $1,000 a month in your 401k, the $1,000 will transfer from your employer to your 401k thereby lowering your paycheck to $4,000. You will then be taxed at your regular rate on the $4,000 you receive.
The $1,000 you invest will grow over time and will not be taxed when it grows. When you decide to take money out of your 401k, after the age of 59 1/2 you will pay taxes on the money you take out of your account. For instance, if you are still receiving $4,000 a month and take out $1,000 from your 401k, you will pay taxes on the $5,000 in income at your regular rate.
How A Tax Exempt 401k Works
A tax-exempt 401k is referred to as a Roth 401k. While not truly exempt from all taxes, a Roth pays taxes upfront, but nothing on the gains or withdrawals. When you invest money in a Roth, you invest after-tax money in this account.
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Withdrawing Before Age 59
For individuals 59½ years old and younger, the early withdrawal penalty is 10 percent. Youll also have to pay income tax on what you withdraw, which in 2021 can range from 10 to 37 percent.
Plus, the withdrawal can impact your income taxes in one other way. Making annual plan contributions to your 401 reduces your taxable income. So if you withdraw a significant amount from your 401 account, it could push you into a higher income tax bracket and you might owe more in taxes.
Lets look at an example of what a withdrawal can potentially cost you when youre 59½ years old or younger.
Say you take out $40,000 to pay off a high-interest credit card and a student loan. Right away, youre charged the 10 percent penalty, which is $4,000. Next, youll owe income tax on that $40,000. If youre a single-income earner who makes $40,000 in 2021, your annual salary is in the 12 percent income tax bracket. However, this $40,000 withdrawal will put you in the next bracket with a tax rate of 22 percent, which means an additional $8,800 of your withdrawal will go toward taxes.
So, that $40,000 youre taking out will cost you $12,800 in taxes and fees, leaving you with $27,200 to apply to your debts.
Youll Have To Adjust Your Budget If You Take A 401 Loan With Retirement Savings
If you dont have another option for your debt but are wary of withdrawing from your retirement savings, you may consider a 401 loan.
- Limitations: Up to 50% of savings or $50,000 , in a 12-month period. Some plans dont allow 401 loans.
- Payback: Within five years and with interest, which goes into the 401 if you leave your job, you must pay back the loan first.
- Taxes and penalties: None if you meet the terms of the loan. If you dont repay the loan, youll be charged taxes and penalties.
- Costs: Youll miss out on possible account growth during your loan repayment period.
Caution is key, Poorman says: A 401 loan is just thata loanso youll be required to make monthly payments. That will reduce your monthly income, so make sure it doesnt put you in a worse situation for the immediate future, he says.
Learn how to make the most of your budget .
Each month you have income that you can divvy up however you wantretirement, vacations, dinners out, and more. Its all about tradeoffs, Poorman says.
Your money is a tool for you to balance those tradeoffs and achieve your goals. Fundamentalsa budget that aligns with your income and expensescan help. And you may have debt repayment choices that help ease some of the pressure, Poorman says, including consolidation or negotiating with a creditor to figure out a reasonable repayment schedule.
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Stop Digging The Debt Hole
Its essential to stop racking up debt when you stop working. That might sound obvious, but its not always so clear for some retirees, says Paul Miller, a New York-based CPA.
Many people think that when they retire, their expenses go down, but they tend to increase, says Miller, owner of Miller & Company, LLP. Retirees want to do things that cost money, like travel. Some people buy a dream retirement home, when they should be downsizing, Miller says.
When youre on a fixed income in retirement, take extra care not to add more debt. Thats especially true of high-interest debt, like credit card debt. If you hope to get free of what you owe, that means living well within your means so you have resources to pay down existing debt while eschewing more.
Use A Reverse Mortgage To Pay Mortgage Debt
Another way to tap home equity without incurring another monthly debt payment is a reverse mortgage. This tool can be used by people aged 62 and over to borrow against their home equity, and payments arent required until the borrower sells the house, moves or dies.
If youre not ready to give up ownership in your home, you might consider a reverse mortgage home equity line of credit, which makes that money available if you need it in case of emergency. Reverse mortgages have a checkered past, but new regulations have cleaned up the industry, to a degree. Still, proceed with caution.
If their retirement plan is tight already, which is the case for many, a retiree can monetize their home by replacing their mortgage with a reverse mortgage, says Chen. The benefit is that they would free themselves from monthly payments without depleting their retirement assets.
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Dont Try To Fix Mistakes With Bigger Mistakes
Some people end up in retirement and realize they havent saved nearly enough, then make rash decisions in an effort to make up for lost time. That can be catastrophic, Miller warns.
People become day traders. They do things outside their normal personality and they jeopardize their retirement, Miller warns. Hes seen plenty of cases where one spouse doesnt tell the other about these risky steps until things really go south. And most often, its irreparable at that point, he says.
If you havent saved enough for retirement, look for ways to maximize your available retirement funds. That could mean working longer to delay taking Social Security, which offers you larger monthly payments the longer you defer it, or
Exceptions For 401 Only
- You leave your job the year you turn 55 or later .
- The 401 is divided in a divorce under whats known as a Qualified Domestic Relations Order.
- You overcontributed to your 401.
Theres also an exception to the early withdrawal penalty for a 401 if you receive a hardship distribution. This is money taken out of your 401 to meet an immediate and heavy financial need, according to the IRS, and could include things like repairing damage to your home after a natural disaster, covering funeral expenses for a loved one, or paying rent to avoid eviction. And youre only allowed to take out the exact amount needed for these expenses.
But even as it becomes easier to access your 401, remember that youre the one who has to live off that money when you retire. So be careful about what you call an emergency and save your 401 for later.
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Nonbankruptcy Options To Repay Debt
If you have income or assets you can use to pay your debts, consider nonbankruptcy options as well. You could:
- negotiate reduced payment plans or lump sum settlements with your credit card creditors
- go on a strict budget and methodically pay down your debt , or
- get help from a consumer credit counseling service
See If You Have A 401 Match And Maximize The Match
If your company encourages retirement savings through some kind of matching arrangement, like a 401 match, even all debt is bad proponents would recommend you invest at least enough to capture that free money.
If your employer pays you 50 cents for every $1 you put away up to 6% of your salary, thats a 50% return right away, or when the savings vest. That high return leads most financial advisors to prioritize it over almost all non-mandatory debt repayment.
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Youre Struggling With High
If youre carrying balances on with oppressive interest rates, you could come out ahead by taking a low-interest 401 loan. Imagine trading a credit card balance with a 16 percent interest rate for a 6 percent interest rate 401 loan.
A heavy debt burden poses a risk to your financial security. In fact, financial expert Dave Ramsey recommended eliminating debt before saving for retirement, even if it means sacrificing a company 401 match for a year or two.
funds and instead consult with a non-profit debt counselor.)
Too Much Debt In Retirement Make A Plan And Stick To It
When it comes to paying debt in retirement, older Americans should prioritize their own needs when choosing their strategy, says Miller.
A lot of people have this, I want to leave this for my kids mentality, says Miller, who recommends that your first priority is to take care of your own finances.
If youre retired and feeling overwhelmed by debt, pay for the services of a financial planner or CPA who can help you make a plan to clean up your financial life. Most importantly, follow their advice and stick to the plan.
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Are You Eligible To Withdraw Money From A 401
First, youll have to determine whether you are able to use your 401 savings to pay debt. Your plan administrator and the IRS guidelines are great resources but generally, 401 distributions are allowed if:
- You reach age 59 1/2
- You die, become disabled or are otherwise withdrawn from the workforce
- Your employer terminates your plan and doesnt replace it with another
- The distribution is related to a financial hardship
That last one is important because not all employers allow hardship distributions from a 401. Even if your plan does allow hardship distributions, you must demonstrate that the funds will address an immediate and heavy financial need. That includes things like:
- Paying medical expenses for yourself, your spouse or your dependents
- Purchasing a principal residence
- Paying tuition, educational fees or room and board for yourself, spouse or dependents
- Avoiding eviction or foreclosure
- Funeral expenses
Keep in mind that every employer is different. Even if your employer allows a hardship distribution, they may not recognize each of these scenarios. In most cases, you wont be able to contribute to your plan within six months of taking a hardship withdrawal.
Alternatives For Reducing Your Debt
Taking money out of your 401 should be a last resort, and even then, it might not be worth it. If you are having trouble reducing your debt there are alternative strategies you could use, like renegotiating your interest rate, taking out a debt consolidation loan, or debt settlement.
You can find help managing your debts through consumer credit and debt relief solutions offered by companies like Americor.
Contact a certified debt consultant today to receive a free debt analysis.
Click here to apply:
*This is for general, informational purposes only, and it is not intended to provide and should not be relied on for tax advice. Please consult your tax advisors before engaging in any transaction.
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When Can You Start Using Your 401
You can start using your 401 as soon as you have vested in the account. The vesting schedule varies from plan to plan, but it is typically between one and five years. To determine how long you need to be employed before becoming vested, you can check your employee handbook or contact your employer. If you dont yet have access to your 401 funds, you can look at alternatives, such as taking out a personal loan or using a credit card.
The Dangers Of Taking Out A Loan On Your 401k
I want to stress to you that taking out a personal loan or getting in the habit of borrowing money from your 401k is not a great idea. If you withdraw funds or take a loan from your 401k to pay your debts, there is no guarantee you fixed the problem that got you in debt in the first place. Remember, you are punishing your future self and your ability to retire comfortably by using it today.
Focus on getting out of debt the old fashioned way, by spending less and saving more! Build better spending habits and show your debt whos boss!
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Major Hardship Withdrawal To Access 401k
There are certain situations where you can access your 401k funds while still employed. If you qualify for an IRS allowed major hardship you may access your money early but will still be subject to a 10% early withdrawal penalty.
According to the IRS, a major hardship withdrawal can be defined as:
- Certain medical expenses
- Costs related to buying a home
- Educational expenses
- Needing money to avoid eviction or foreclosure on a primary residence
Generally, the IRS relies on the employer to ensure the employee takes distributions related to the hardship.
What Are The Different Types Of Retirement Accounts
Before considering the costs of early withdrawal, its important to understand the difference between traditional and Roth accounts. Each is handled differently in case of early distribution.
A traditional retirement account is contributed to with pre-tax dollars. Contributions and earnings will be taxed when distributed.
A Roth retirement account is contributed to with taxed dollars. Contributions and earnings will be distributed tax-free.
You should also know the difference between the two main types of retirement accounts 401 and IRA.
A 401 is an employer-sponsored plan typically made up of funds chosen by your employer. If you have automatic contributions from your paycheck into a retirement account, you likely have a 401 plan. Many employers also offer a Roth option.
An IRA, or individual retirement arrangement, isnt employer-sponsored. You open it yourself and choose the funds that make it up. Traditional and Roth options are available for your IRA. If you need help opening an account, check out this NerdWallet article on how and where to open an IRA.
Normally, retirement accounts cant be distributed until after the age of 59½. If you withdraw money early, youll have to pay taxes and penalties. Youll also miss out on the biggest benefit of investing future gains.
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