How to Cash out a 401(k) to Pay off Debt

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If you reach age 59 1/2, leave your job or suffer a disability, you can cash out your 401(k) at any time. Otherwise, you can ask your employer to release cash from your 401(k) account to pay debts arising from financial hardship, an Internal Revenue Service levy for back taxes or a court-ordered divorce settlement. You'll have to fill out certain paperwork explaining the request before the 401(k) trustee will release the money to you. Regulations limit the types of hardships that qualify for early cash out, and you will be subject to taxes, withholding and possibly an early withdrawal penalty.

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Severity of Need

To qualify for a financial hardship, you must show you need the money because of an immediate, necessary and heavy need. Your employer must apply objective and nondiscriminatory standards to gauge the severity of your need. For example, your employer may block your access to 401(k) cash to pay off a debt from the purchase of a boat or big-screen TV but will OK funds to pay for the funeral of a family member or for an urgent medical need.

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Permitted Reasons

The IRS regulations lists six hardship reasons that indicate immediate and pressing need: repairing damage to your home, paying funeral costs of a close relative, avoiding foreclosure or eviction, paying for qualified education expenses, buying your main home and paying medical costs. You must reduce these costs by any reimbursements you receive. The rules permit the Internal Revenue commissioner to qualify other extraordinary or unusual events as hardships.

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Restrictions on Hardship Disbursements

You may qualify for a 401(k) hardship disbursement to pay off your debt, but you must observe certain restrictions. You can receive only enough to satisfy the debt and any penalties or taxes arising from the withdrawal. You must also show that you have reasonably exhausted your other options to raise the money, such as selling your vacation home or getting a bank loan. You can withdraw money you contributed but not earnings on that money. After receiving the money, you have to wait six months before contributing to a retirement plan.

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Advantages and Disadvantages

The main advantage of a hardship withdrawal is that you get money you really need. The downside includes the loss of tax-free earnings on the money you withdraw, the 20 percent tax withheld by your employer, the tax bill for the distributed amount and a possible 10 percent early withdrawal penalty. However, you can avoid the penalty if the money is to pay debt related to a disability, medical treatment, divorce settlement or IRS levy or if you've left your job after reaching age 55. One alternative is to borrow money from your 401(k), which won't trigger taxes, withholding or penalties; 401(k) loans are subject to rules concerning the maximum amount, interest rate and payback deadline.

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