What happens if you withdraw from your 401(k) early?

A 401(k) is an employer-sponsored investment account that allows employees to contribute a portion of their salary, making it easier for them to save for retirement. Most 401(k)s allow you to invest in the stock market through stocks, bonds, mutual funds, and money market funds. 

You can withdraw money from a 401(k) when you meet a distributable event, as defined in your plan document. Still, you could end up paying penalties and increasing your taxable income in the distribution year. Here’s some more information about how early 401(k) withdrawals work.

Cashing out a 401(k): How is it taxed?

The IRS requires 20% federal tax withholding on any cash distribution from a retirement plan that was eligible to be rolled over to an IRA or another retirement plan. In addition, some states have required withholding on retirement distributions.

Example: If you take $10,000 from your 401(k), you’ll get $8,000 in cash after federal withholding. If you’re less than 59 ½ years old, the IRS may assess a 10% penalty (unless an exception is met). That means you’ll be assessed another $1,000 in taxes when you file your tax return. In addition, any losses you have in the account will be realized upon liquidation. You won’t be able to regain any of your losses if the market rebounds.

What to consider when cashing out your 401(k)

If you decide to cash out your 401(k), you should see if you qualify for an exemption from the penalty. The IRS will waive it if you choose to receive a series of equal payments that start after you stop working and continue to receive payments for life. 

You must receive at least one payment per year for at least five years or until you become 59 ½, whichever event comes last. This is usually accomplished by rolling your account to an annuity provider, who will assist with processing the installment payments.

You can also avoid the penalty if you leave your job in the year you turn 55 or later. Other reasons for an exception to the penalty include:

• Being disabled

• Rolling your account over to another retirement plan within 60 days of the initial cash distribution

• Sending the money to your beneficiary or your estate after you die

• Paying an IRS levy

• Applying for IRS tax relief for victims of natural disasters

• Overcontributing or auto-enrolling in a 401(k) and then deciding to reduce those contributions

• Being a military reservist called to active duty

Hardship distributions

Hardship distributions may be offered by your plan. The amount is limited to your immediate financial need. You may qualify for a hardship distribution if you meet one or more of the following circumstances:

• Medical bills for you or an immediate family member

• Purchase of a primary residence

• College tuition, along with room and board

• The money you need to avoid foreclosure or eviction

• Funeral expenses for you or a dependent

• Repair costs after damage to your home due to a natural disaster.

Keep in mind that the cost of an early withdrawal includes taxes and penalties. You’ll also lose the opportunity to continue making money by keeping your funds invested in your 401(k).

How taxes can impact your income

People who contribute to 401(k)s before the IRS withholds taxes from each paycheck reduce the amount of income they must pay tax on during their working years. After you retire and start withdrawing from your 401(k), you’ll have to pay taxes on that income. However, your tax rate is likely to be lower as a retiree.

If you contribute Roth deferrals and/or receive Roth employer contributions, you won’t owe any income taxes on the contribution when the amount is withdrawn. The earnings on the account may be tax-free as well, if it is considered qualified.

Cashing out an old 401(k)

If you leave your employer, you may want to keep your money in your prior employer’s 401(k). Even if you can’t contribute to it anymore, it can still earn interest. Cashing out an old 401(k) early could cost you a sizeable amount in penalties and lost growth.

After termination, you can ask your former employer’s 401(k) plan administrator for a cash withdrawal, and they will distribute your 401(k) and mail you a check. You will receive the net amount of approximately 80% of your current account balance after the required 20% federal withholding plus applicable state withholding. Depending on your tax bracket, you could get a refund for some of those funds, or you may need to pay an additional amount, especially if you’re under age 59 ½ and do not qualify for an exception to the 10% early withdrawal penalty. 

If you wait until you turn 59 ½ to cash out your 401(k), you’ll still have to pay regular income taxes, but you avoid the additional 10% penalty. Because the tax rules vary based on age, state, and your personal situation, it’s best to work with a financial professional before you take a withdrawal if you have any questions or concerns. 

What happens when you take an early 401(k) withdrawal

Your money goes in tax-free when you contribute pre-tax funds to a 401(k). This lets you earn interest on money that would otherwise go toward taxes, making the amount your 401(k) ends up with much larger. Even though you still have to pay regular income taxes on what you earn, you’ll be able to keep more cash than you would without taking advantage of this tax benefit.

The IRS taxes 401(k) distributions at your ordinary income tax rate, whether you make a withdrawal before or after you’re 59 ½. However, early withdrawals often lead to a 10% penalty. The normal income tax rate for working people is usually higher than it is for retirees, as well.

After you withdraw your savings from a 401(k) account, that money could be very difficult to replace. 401(k) plans place limits on the amount that you can contribute each year. A large withdrawal could place your retirement plan years behind schedule, and you may never be able to get fully back on track.

Ultimately, using funds from your 401(k) to pay off a car loan or eliminate credit card debt sounds tempting, but this could be extremely costly over time. Delaying withdrawals until you become 59½ to avoid the 10% penalty can assist you in increasing your retirement benefit. Consider letting your funds earn additional returns for as long as possible. That way, you can maximize the potential to receive more income from interest in the long run.