A 401(k) is an employer-sponsored retirement savings account set up under federal tax rules. These "defined-contribution" accounts are gradually replacing the traditional "defined benefit" company pensions that promised a certain monthly income amount after retirement. Your employer's contributions to a 401(k) earn income that is tax-deferred until you begin withdrawing it, preferably after you stop working. Although early withdrawals are legal, there are some important caveats to keep in mind.
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IRS rules permit early withdrawals from a 401(k), but your employer's account custodian enforces its own procedures and guidelines for doing so. Although legally it's your money, the funds in a 401(k) enjoy certain tax advantages that will be lost for any early withdrawal. You'll also pay a penalty for raiding the account early.
Cashing out a 401(k) in most cases takes the form of a loan from the account. The loan will be charged interest, which continues to accrue until the balance is paid in full. The repayment of the loan as well as the interest goes back to the same account, so technically you're simply paying the money and the interest to yourself. However, the account may have vesting rules, meaning you're only entitled to a portion of the money until you've worked for the employer a minimum number of years. Each plan sets limits on funds available for borrowing, with a general rule setting this limit at half of the vested balance
Penalties and Waivers
You can keep some or all of the money from your 401(k) loan, but there's a big financial downside. If you leave your job and don't repay that loan within 60 days, the IRS considers you to have taken a withdrawal from the account, and slaps a 10 percent penalty on the total amount still outstanding. There are a few exceptions to this rule; there's no penalty for withdrawals to pay a federal tax levy, for example, or for the payment of large medical bills. The penalty is also waived if you take the withdrawal at age 59 1/2 or later.
Loan Terms and Repayment
You can avoid the early-withdrawal penalty by keeping to the repayment terms on the loan, which can be extended over several years. Employers are allowed to set the repayment schedule and limit the amount of money loaned. Keep in mind that money loaned out is no longer earning income within your 401(k), and that loan interest is not tax-deductible.