A 401K is an employer-sponsored retirement savings plan that employees can contribute to pre-tax, thus reducing their annual tax liability. Some employers also contribute to the account as a benefit to the employee.
A 401K is a valuable part of a long-term financial and retirement plan that all employees should take advantage of.
But you may be in a financial situation and considering cashing out your 401K. Before doing so, you need to consider the consequences carefully. Here, we’ll cover what steps to take before you make the decision.
Understand the Consequences Before Cashing Out a 401K
While it may be tempting when you see those contributions in your payroll statement add up, an early withdrawal from a 401K has financial consequences. First of all, the withdrawal will be considered income and, therefore, subject to income taxes that year.
The IRS also generally assesses a 10% penalty on the amount withdrawn if you’re under age 59 ½. Both of those combined add up to a big chunk of your withdrawn funds being lost.
For example, if you withdraw $10,000 and you’re in a 22% tax bracket, you’ll be responsible for income tax of $2,200 plus a 10% penalty of $1,000 for a total of $3,200.
Additionally, you will be negatively impacting your long-term financial and retirement plan. That may ultimately result in delaying your retirement.
Assess your financial situation
First, assess your financial situation to determine if you really need to cash out. What’s the money for? Is it for necessary expenses?
If it is, determine if you have other resources to turn to, such as a savings account or even a credit card. Both may be a less expensive option. You could also liquidate other assets that you own.
If you don’t have the necessary expenses and you just want the money to make a purchase or take a vacation, you need to seriously consider whether cashing out is worthwhile based on the financial consequences.
Explore alternative options
If you really need or want the cash but you don’t have other resources, your best option may be obtaining a 401K loan. You could access funds but then make payments back to your account. That means you’re essentially making payments to yourself. As long as you pay it back under the terms allowed by your plan, you won’t have tax consequences, and you won’t be impacting your long-term financial plan.
You can generally borrow up to 50% of your vested account balance or $50,000, whichever is less. However, if 50% of your vested balance is less than $10,000, you can borrow up to $10,000.
Generally, the rules are that you must make at least quarterly payments and pay the loan back within five years.
Another option is a hardship withdrawal, which can be taken if your employer that sponsors the plan determines that you have “an immediate and heavy financial need.” Your plan must allow for hardship withdrawals and provide specific criteria for those withdrawals.
The IRS rules state that the distribution is deemed necessary if it meets the following criteria:
- The distribution isn’t greater than the amount of the immediate and heavy financial need, including the amounts necessary to pay any taxes resulting from the distribution.
- The employee has obtained all other currently available distributions (including distribution of ESOP dividends under section 404(k), but not hardship distributions) and nontaxable (at the time of the loan) plan loans, including all other plans maintained by the employer.
- The employee isn’t allowed to make elective deferrals to the plan for at least six months after the hardship distribution.
Generally, expenses deemed as an immediate and heavy need can include:
- Certain medical expenses
- Costs of purchasing your principal residence
- Tuition and educational fees
- Funds needed to prevent eviction or foreclosure
- Burial/funeral expenses
- Certain expenses for the repair of your principal residence
- Expenses and losses (including loss of income) incurred by an employee due to a federal disaster declaration but only if the employee’s principal residence or place of employment was located in the disaster zone and designated for individual assistance.
Additionally, your employer has to determine that your immediate financial need can’t be met with other resources. Generally, they can determine this just based on your written statement.
The hardship distribution can generally only be made from elective deferrals and matching contributions, not from earnings on those amounts. Some plans also only allow you to withdraw vested funds. Vesting refers to a schedule in which you become vested gradually based on your time of employment. For example, your plan may not deem you fully vested until you’ve worked for the employer for five years.
The hardship distributions will be subject to income taxes and may still incur the 10% penalty, which is why a 401K loan is the better option.
Review retirement goals
It’s a good idea to review your retirement goals before you decide and consider the impact of the cash-out on those goals. You need to weigh your need for funds with the potential impact on your retirement. Factors to consider include the amount of time you have before you want to retire and the amount of money you’ll need to have saved to maintain your lifestyle during retirement.
You should have a long-term retirement savings plan in place, but if you don’t, now is the time to make one so that you can see the impact of the cash-out within the context of your plan.
Create two plans, one that includes the immediate cash-out and one that does not. This will tell you whether you have time to make up for the withdrawal with future savings efforts or if the withdrawal may delay your retirement or impact your retirement lifestyle.
Looking at things in the big picture can give you a different perspective on your need for funds.
Consider Rollovers and Transfers
If you’re leaving your job and considering cashing out your 401K for that reason, you have alternatives to avoid taxes and penalties.
You have the option to rollover or transfer your funds into another retirement plan, such as an IRA. Suppose you take out the money and deposit it into a different retirement account. In that case, it’s considered a rollover, and you have to deposit the money into the new account within 60 days of the withdrawal.
You can also generally have your plan administrator or your financial institution directly transfer the funds to the other retirement account.
With either option, as long as you meet the deadline, you won’t pay taxes or penalties on the funds.
By choosing one of these options, you’ll save money and keep your retirement plan in place.
Consult Financial Advisors
Your best bet is to consult a financial advisor before making any decisions or taking any actions. They can review your entire financial situation to help you weigh the pros and cons of your options and make an informed decision.
An advisor can also review your full retirement plan or help you create one based on your financial situation and goals. Financial advisors have specialized tools and knowledge to calculate how much you need to save to live the retirement lifestyle that you want.
Additionally, they can help you with the process if you choose a rollover or transfer.
Plan for future contributions
Whether you choose to cash out or not, you need to plan for future contributions into your 401K or other retirement accounts. Remember that what you save also earns a return depending on your chosen investment vehicles. Let your money make money for you.
Even small contributions over time can grow into a substantial nest egg. Consistency is key – starting early and contributing consistently can make a remarkable difference in the eventual size of your retirement fund.
Unfortunately, many people fail to save for retirement at all. According to the United States Census Bureau 50% of women and 47% of men ages 55 to 66 have no retirement savings. Don’t put yourself into that category. Your only option will be to continue working for as long as you can.
Saving for retirement is fundamental to ensuring financial security and peace of mind during your golden years. As life expectancy continues to increase and the landscape of retirement benefits shifts, the importance of actively setting aside funds for retirement has never been greater.
In retirement, you deserve the freedom to enjoy your time without the burden of financial stress. A healthy retirement savings provides a safety net that allows you to maintain your desired lifestyle, pursue hobbies, travel, and spend quality time with your family.
Many people sometimes find themselves in financial situations that require immediate cash. But before cashing out your 401K, you must be informed about the consequences and explore all alternatives. You can talk to your plan sponsor about 401K loan options or hardship withdrawal requirements, but you should also seek the advice of a financial advisor. You’ll want to make the decision that’s best for you in the short term and in the long run.