Reasons For Cashing Out A 401k
Its important to remember that your 401k is the money you have set aside to pay for your future expenses. It is protected if you have to declare bankruptcy, while your other assets are not. Cashing out a 401k before you reach retirement age should be a last resort. Still, if you face any of the following situations, you may choose to cash out your 401k:
- You may need to cash out your 401k to help pay bills while you are unemployed.
- Cashing out a 401k may make sense when you are facing large medical bills.
- You may cash out your 401k when there is a small amount of money in it.
- You might consider cashing out a 401k to save your home or for a down payment on a home.
- Consider a 401k cash out to cover education costs for your spouse or children.
When Does A 401k Early Withdrawal Make Sense
In certain cases, it actually might be strategic to move forward with 401k early withdrawal. For example, it could be smart to cash out some of your 401k to pay off a loan with a high-interest rate, like 1820 percent. You might be better off using alternative methods to pay off debt such as acquiring a 401k loan rather than actually withdrawing the money.
Always weigh the cost of interest against tax penalties before making your decision. Some 401k plans do allow for penalty-free early withdrawals due to a layoff, major medical expenses, home-related costs, college tuition, and more. Regardless of your strategy to withdraw with the least penalties, your retirement savings are still taking a significant hit.
Penalties And Taxes On Cashing Out A 401k
When you complete a 401k cash out, you will need to pay an early withdrawal penalty and 401k taxes on your withdrawal. The 401k early withdrawal penalty is 10% of the amount that you withdraw. You will also be taxed at your normal income rate on the amount that you withdraw. Most plans will withhold 20% of the amount that you withdraw and send it to the IRS to help cover the costs and will send you a 1099-R form. If your tax rate is higher than 10%, then you will need to be prepared to pay additional money when you file your taxes. It is important to be prepared for this possibility.
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Youll Face A Hefty Tax Bill
On top of the 10% penalty, youâll owe taxes on the amount you withdraw from your 401.
Your plan administrator is required to withhold 20% of your withdrawal for taxes. However, depending on your income bracket, this may not cover your entire tax obligation.
If youâre unable to come with the rest when you file taxes, you may be left with more costly options to pay the remaining taxes.
Is Your 401k A Security Blanket
Most of us look at our 401k as a security blanket â something that we intend to pull out when we are suffering in the cold. There are a number of financial hardships that might tempt you to consider taking an early withdrawal:
- Urgent medical emergencies
- Rising college tuition costs
- Pressing home improvement needs
This 401k withdrawal calculator will help you decide whether to take a lump-sum distribution or to rollover to a tax-deferred account. Its side-by-side comparison of data gives you the information you need to make a decision that is right for you.
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Consequences Of A 401 Early Withdrawal
- IRS Penalty. If you took an early withdrawal of $10,000 from your 401 account, the IRS could assess a 10% penalty on the withdrawal if its not covered by any of the exceptions outlined below.
- Withdrawals are taxed. Even if it were covered by an exception, all early withdrawals from your 401 are taxed as ordinary income. The IRS typically withholds 20% of an early withdrawal to cover taxes. So if you withdrew $10,000, you might only receive $7,000 after the 20% IRS tax withholding and a 10% penalty.
- Less money for retirement. Perhaps the biggest consequence of an early 401 withdrawal is missing out on long-term returns in the market. The stock markets average returns have been around 9.6% a year since the end of the Great Depression. If you withdrew $10,000 from your 401 and were about 30 years away from retirement, you could be giving up more than $117,000 in total returns.
No More Creditor Protection
As long as your money’s in a 401 plan, it’s creditor-protected, meaning that it’s shielded in the event of bankruptcy. It is unwise to cash in a 401 plan to pay down your debt if it is likely that you will end up filing bankruptcy. The bankruptcy court cannot touch the money in your 401 plan, and creditors cannot 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.
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Will The Full Balance Be Available To You
If you are withdrawing from an employer-based account and are relatively new to your job and are not considered fully-vested for retirement purposes, the portion of the funds that were contributed by your employer may not be available to you. Even if you are fully vested, your employer may not allow you to access that portion of your account. Remember, the special tax treatment does not apply to more than $100,000 total.
Cashing Out Your 401k While Still Employed
The first thing to know about cashing out a 401k account while still employed is that you cant do it, not if you are still employed at the company that sponsors the 401k.
You can take out a loan against it, but you cant simply withdraw the money.
If you resign or get fired, you can withdraw the money in your account, but again, there are penalties for doing so that should cause you to reconsider. You will be subject to 10% early withdrawal penalty and the money will be taxed as regular income. Also, your employer must withhold 20% of the amount you cash out for tax purposes.
There are some exceptions to the rule that eliminate penalties, but they are very specific:
- You are over 55
- You are permanently disabled
- The money is needed for medical expenses that exceed 10% of your adjusted gross income
- You intend to cash out via a series of substantially equal payments over the rest of your life
- You are a qualified military reservist called to active duty
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What Is A 401 Early Withdrawal
First, lets recap: A 401 early withdrawal is any money you take out from your retirement account before youve reached federal retirement age, which is currently 59 ½. Youre generally charged a 10% penalty by the Internal Revenue Service on any withdrawals classified as earlyon top of any applicable income taxes.
If youre making an early withdrawal from a Roth 401, the penalty is usually just 10% of any investment growth withdrawncontributions are not part of the early withdrawal fee calculation for this type of account.
But the entire account balance counts for calculating the fee if youre making an early withdrawal from a traditional 401. These rules hold true for early distributions from a traditional IRA as well.
Roll Over Your Assets To An Ira
For more retirement investment options and to maintain the tax-advantaged status of the account, roll your old 401 into an individual retirement account . You will have greater flexibility over access to your savings .1 Before-tax assets can roll over to a Traditional IRA while Roth assets can roll directly to a Roth IRA. Review the differences in investment options and fees between an IRA and your old and new employers 401 plans.
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If Im Eligible Should I Take A Distribution From My 401 Or Ira
Even with the new rules in place, its still advisable to exhaust most other resources, such as emergency funds or other easily accessible forms of savings, before tapping into your retirement accounts.
But if you are considering taking a distribution from your IRA or 401, think through the following first.
Risks Of A 401 Early Withdrawal
While the 10% early withdrawal penalty is the clearest pitfall of accessing your account early, there are other issues you may face because of your pre-retirement disbursement. According to Stiger, the greatest of these issues is the hit to your compounding returns:
You lose the opportunity to benefit from tax-deferred or tax-exempt compounding, says Stiger. When you withdraw funds early, you miss out on the power of compounding, which is when your earnings accumulate to generate even more earnings over time.
Of course, the loss of compounding is a long-term effect that you may not feel until you get closer to retirement. A more immediate risk may be your current tax burden since your distribution will likely be considered part of your taxable income.
If your distribution bumps you into a higher tax bracket, that means you will not only be paying more for the distribution itself, but taxes on your regular income will also be affected. Consulting with your certified public accountant or tax preparer can help you figure out how much to take without pushing you into a higher tax bracket.
The easiest way to avoid these risks is to resist the temptation to take an early 401 withdrawal in the first place. If you absolutely must take an early distribution, make sure you withdraw no more than you absolutely need, and make a plan to replenish your account over time. This can help you minimize the loss of your compound returns over time.
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When You Need Money
If you find you need some emergency money, you could consider taking money out of your tax-free savings account, or TFSA, as long as you repay the money the next year. Also, to lessen the cost of investment growth, you should repay the account as soon as you can.
Consider using non-registered financial assets, like guaranteed investment certificates, segregated funds or savings bonds. If you can, you should use these before you tap into your RRSP.
Also, consider taking out a line of credit if you need a way to tap into emergency cash. Youll be able to get to the funds when you need them, without having to re-apply each time. Also, lines of credit usually carry a lower interest than fixed term loans do. Also, your interest rates are likely to be lower.
If you have the discipline to pay off an RRSP loan, you might be better off seeing if you could cut your monthly expenses, and save the money for an emergency.
There may be a few advantages to tapping into some of your RRSP early if taxes are your concern. One example would be if you were taking parental leave, your earnings will drop, and your withdrawal will get taxed at a lower rate. Also, if you have a pension plan at work that will put you in a higher tax bracket after retirement, there may be some advantages to withdrawing part of your RRSP before retirement age.
What To Ask Yourself Before Making A Withdrawal From Your Retirement Account
There are many valid reasons for dipping into your retirement savings early. However, try to avoid the mindset that your retirement money is accessible. Retirement may feel like an intangible future event, but hopefully, it will be your reality some day. So before you take any money out, ask yourself: Do you actually need the money now?
Think of it this way: Rather than putting money away, you are actually paying it forward. If you are relatively early on in your career, your present self may be unattached and flexible. But your future self may be none of those things. Pay it forward. Do not allow lifestyle inflation to put your future self in a bind.
With all this talk of 10% penalties, and not touching the money until youre retired, we should point out that there is a solution if you feel the need to be able to access your retirement funds before you reach age 59 ½ without penalty.
Contribute to a Roth IRA, if you qualify for one.
Because contributions to Roth accounts are after tax, you are typically able to withdraw from one with fewer consequences. Keep in mind that there are income limits on contributing to Roth IRAs, and that you will still be taxed if you withdraw the funds early or before the account has aged five years, but some people find the ease of access comforting.
For some folks, however, a Roth-type account is not easily available or accessible to them.
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Thinking Ahead: The Long
Moving jobs is a tricky time financially. You might have to move cities or adjust your fuel budget to cover a longer commute. There is also a heap of paperwork associated with transferring any retirement funds from one company to another.
It is tempting to cash out your 401 when you need capital its even more tempting if youve been cut back or are battling against debt. While it might seem like an easy way to access the funds you need, this seemingly small amount is set to get you through the years when you dont earn a fixed income, and putting this security in jeopardy can be catastrophic.
The issue is replacing your hard-earned savings. Unlike normal rainy day funds, this is an account designed to cover your retirement. Can you really afford to sacrifice years of savings for a quick fix? The reality is that debt and unexpected costs can make it difficult to save, so raiding the retirement fund is a consideration that shouldnt be taken lightly.
The reason these savings should be protected at all costs is that they are structured to deliver gradual growth over a significant investment period. They give you the security of compound growth thats not touched by tax and make it possible to save a substantial amount.
Its even possible for the earnings from the interest in these accounts to start earning outright, which makes them vastly superior for long-term planning.
All You Need To Know Is Yourself
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The above article is intended to provide generalized financial information designed to educate a broad segment of the public it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
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Consider The Pros And Cons
Early withdrawals from your hard-fought savings should be considered carefully. There are many factors to consider with long-term implications. Study the alternatives available and make decisions according to your ultimate goal.
Whether you decide to keep your 401k contributions intact with your old employer, move it to your new employer, roll it over to an IRA, or simply cash it out, the question of taxes and penalties loom.
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There are pros and cons to taking a lump-sum distribution. Four important factors to consider include:
In summary, there are many conflicting issues you must balance. Lifestyle needs, taxes, and penalties today versus future savings tomorrow. It is a difficult decision.
How To Withdraw 401k Money
As with any decision involving taxes, consult with your tax professional on considerations and impacts to your specific situation. An Edward Jones financial advisor can partner with them to provide additional financial information that can help in the decision-making process. When considering withdrawing money from your 401 plan, you can withdraw in a lump sum, roll it over or purchase an annuity. Your financial advisor or 401 plan administrator can help you with this.
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You May Be Hurting Your Retirement
Every dollar you take from your 401 or IRA today means less youll have in retirement much less, thanks to compounding interest.
Lets say you have $50,000 in your 401, and you take a $5,000 penalty-free distribution. If you dont pay it back, not only will you forgo the tax refund, youll miss out on substantial long-term growth.
In this scenario, $50,000 could grow to about $160,400 after 20 years without any additional contributions. Conversely, $45,000 might only grow to about $144,300. So the $5,000 paid the bills in the short term, but cost you about $16,000 in the long term. Use our 401 withdrawal calculator to explore your specific situation.
Tips On Paying Down Debt
- You may be able to secure a personal loan to cover an unexpected payment instead of tapping into your 401. We developed a personal loan calculator to help you figure out payment methods.
- As you can see, you can run into some serious tax hits even if you manage to take out a hardship withdrawal from your 401 or any other retirement plan for that matter. A financial advisor can help you find alternatives that work best for your personal situation. We can help you find one with our SmartAsset financial advisor matching tool. You answer some simple questions about your needs and it connects you with up to three advisors in your area. You can even review their profiles before working with one.
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