401k plans are tax shelters that defer income tax due on your retirement savings. This deferral of tax helps you accumulate a large retirement account balance. However, if you ever decide that you don't want to keep your 401k, you can cash it out. If you do, you must know how much it costs to cash out your retirement plan.
There are two types of 401k plans. The traditional 401k is the most common. Pre-tax contributions are made to the 401k plan. Then, the contributions are invested. Withdrawals are taxed at ordinary income tax rates. Roth 401k plans allow after-tax contributions and do not tax withdrawals.
The significance of cashing out a 401k plan is that it will cost you in income taxes. Cashing out a 401k plan triggers a tax liability. You pay tax based on your 401k funds as ordinary income. If you are under 59 1/2, you also pay a 10 percent penalty for early distribution from your 401k.
The benefit of cashing out your 401k plan is that you receive your money prior to retirement and can do whatever you want with it. You may reinvest the funds into any type of investment, or you can spend the money on something else.
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The disadvantage to cashing out your 401k early is that you are cashing in your retirement fund. When you retire, you may not have enough money to live on. This could place you in a financial hardship when you are unable to work anymore.
Consider keeping your 401k plan. If you want access to the funds, and your employer allows loans, consider taking a loan from your 401k plan instead of cashing it in. 401k plan loans may be taken up to $50,000. If your employer allows in-service withdrawals, you can convert your 401k plan to a Roth IRA instead of cashing in the 401k plan outright. By converting to a Roth IRA, you pay income tax, but no penalty on the conversion. Additionally, you can withdraw contributions from your Roth IRA anytime you wish without a penalty. This means you may convert to a Roth IRA and then withdraw your contributions to the Roth to avoid a 10 percent penalty.