If you've been saving up money in your 401(k) plan, you may be looking for ways to cash it out when a financial hardship hits or when you change jobs. However, if you're not in retirement yet, cashing out your 401(k) could be a very costly mistake because of income taxes and penalties. Knowing the rules can help you decide if you can cash out, and if so, how much it will cost you in taxes.
When You Can Cash Out
Typically, you're only allowed to cash out your 401(k) plan under limited circumstances. These include after you've left your job, become permanently disabled, turned 59 1/2 years old or, if your plan allows it, experienced certain financial hardships. If you don't meet these criteria, you're usually not even allowed to cash out from your 401(k). For example, if you're under 59 1/2 and still working for your employer, you can't just decide to take the money out because you'd like to buy a bigger TV.
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Income Tax Implications
When you cash out your 401(k) plan, the amount of the distribution counts as taxable income and your employer withholds 20 percent of the amount of the distribution for federal income taxes, but your taxes may be higher or lower depending on your marginal tax rate. In addition, if you are under 59 1/2 years old at the time of the distribution, you also owe an additional 10 percent tax penalty because you're making an early withdrawal exemption. For example, if you fall in the 22 percent tax bracket, you could be paying 32 percent — almost $1 of every $3 withdrawn — to the federal government.
Early Withdrawal Penalty Exceptions
You can avoid the early withdrawal tax penalty, but not the ordinary income taxes, if you meet the criteria for an exception for an early 401(k) distribution. If you take a hardship distribution as defined by your plan, that doesn't mean you're exempt from the penalty unless you meet one of the specific exemptions. Exemptions include suffering a permanent disability, leaving your job after you turn 55 years old, making a distribution under a qualified domestic relations order, paying for medical expenses that would qualify for the medical expenses deduction, or because the IRS has levied the plan.
If you are cashing out your 401(k) plan because you are leaving your job and don't need the money, consider rolling the money into another qualified retirement plan instead. Money rolled over isn't taxed or hit with the 10 percent early withdrawal penalty tax. Instead, it continues to grow tax-free in the new account until you take it out in retirement. For example, you may be able to roll your old 401(k) into the 401(k) plan at your new company. Or, if the new company doesn't have a 401(k) plan or doesn't accept rollovers, you could roll the money into a traditional IRA instead that you can set up yourself.