LAST REVIEWED Dec 13 2019 8 MIN READ
By The Human Interest Team
A 401(k) is a type of investment account sponsored by employers. It lets employees contribute part of their salary pre-tax, which makes it easier for employees to save for retirement. Most 401(k)s invest in the stock market through stocks, bonds, mutual funds, and money market funds. You can withdraw money from a 401(k) before you retire, but you could end up paying extra taxes and fees. Here’s some more information about how early 401(k) withdrawals work.
If You Cash Out a 401(k), How Is It Taxed?
The IRS usually withholds 20% of any early 401(k) withdrawal automatically for taxes. For example, if you take $10,000 from your 401(k), you’ll get about $8,000 after automatic withholding. If you’re less than 59 ½ years old, the IRS normally assesses an additional 10% penalty. That means you’ll need to pay another $1,000 when you file your tax return. That’s a total of $3,000 in taxes for your $10,000 withdrawal. If the stock market is down when you make an early withdrawal, you could end up with even less. You won’t be able to regain any of your losses when the market rebounds.
What You Should Know If You’re Still Considering Cashing Out
If you decide to cash out your 401(k), you should see if you qualify for an exemption to 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 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.
You can also avoid the penalty if you leave your job in the year you turn 55 or later. Federal law enforcement, firefighting, border protection, customs, or air traffic control employees can stop work the year they turn 50. If a court order requires you to cash out your 401(k), the withdrawal could be penalty-free. Many workers cash out their 401(k)s and split the proceeds with their former spouse after a divorce. Other reasons for an exception to the penalty include:
Rolling your account over to another retirement plan within 60 days
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
Some people avoid the 10% early withdrawal penalty by converting their 401(k) into an IRA before removing their money. You could also qualify for a hardship distribution for:
Medical bills for you or an immediate family member
The funds to buy a house
College tuition along with room and board
The money you need to avoid foreclosure or eviction
Repair costs after damage to your home.
The cost of an early withdrawal often 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 contribute to 401(k)s before the IRS withholds taxes from each paycheck, reducing 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.
Cashing Out an Old 401(k)
If you leave your employer, you should keep your money in your 401(k) if possible. Even if you can’t contribute to it anymore, it can still earn interest. Cashing out an old 401(k) early will cost you a huge amount in penalties and lost growth.
You can ask your former employer’s 401(k) plan administrator for a cash withdrawal, and they will close your 401(k) and mail you a check. Most of the time, you’ll get 70% of your balance. The other 30 percent covers taxes and fees. Depending on your tax bracket, you could get a refund for some of those funds. However, you may need to pay an additional amount instead. 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 can avoid the additional 10% penalty. Unless you qualify for a hardship distribution, you can’t make a cash withdrawal until you stop working for an employer.
What Happens When You Take an Early 401(k) Withdrawal
When you contribute funds to a traditional 401(k) plan, your money goes in tax-free. That’s a great incentive to participate. It 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.
Whether you make a withdrawal before or after you’re 59 ½, the IRS taxes 401(k) distributions at your ordinary income tax rate. However, early withdrawals often lead to a 10% penalty. The normal income tax rate for people who are working 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.
Using the money from your 401(k) to pay off your car loan or eliminate credit card debt sounds tempting, but it could be extremely costly over time. You should only make an early withdrawal from your 401(k) as a last resort. If possible, leave that money alone until you become 59 ½ to avoid the 10% penalty. Let your funds earn additional returns for as long as possible before you use them. That way, you can receive more income from interest.
To learn more about 401(k)s, check out Human Interest. We offer excellent full-service 401(k) accounts for small and medium businesses.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.