Cashing Out a 401(k): What a 401(k) Early Withdrawal Really Costs

As a retirement savings account, a 401(k) is primarily meant for long-term investments. However, if you're in need of funds, you may be considering whether cashing out a 401(k) early is feasible. It can be tempting to withdraw from a 401(k) before retirement, but it is important to understand the consequences you may face and the real cost of cashing out early.

This article will discuss the rules you need to know for cashing out a 401(k) and help you understand the alternatives you have that may save you money in the long run.

Cashing out a 401(k): are you eligible?

A 401(k) is a retirement plan that is sponsored through an employer. When you contribute to a 401(k), the money is taken from your paycheck and invested in mutual funds and other securities. Most traditional 401(k) plans are tax-deferred, meaning you don't have to pay taxes on the funds until you make a withdrawal.

Anyone can cash out their 401(k), but doing so early may cost you. Since a 401(k) is a retirement fund, there are rules that encourage you to wait until retirement to withdraw funds. The earliest you can usually withdraw from your 401(k) without paying a penalty is at age 59 ½. The requirements vary a bit, however, based on your current employment status.

If you're employed

If you're 59 ½ and still working, you can withdraw from a 401(k) from a past employer without paying an early withdrawal penalty. However, whether or not you can withdraw from the 401(k) provided by your current employer will depend on the rules of your plan.

Some plans allow you to withdraw if you have worked for the company for a specified amount of time, and others will allow you to withdraw contributions but not earnings. Many will not allow any withdrawals at all while you are still with the company.

If you're unemployed

If you're unemployed and age 59 ½ or older, you can freely withdraw from any 401(k) that has funds remaining in it. The withdrawn money will be treated as taxable income but will not be subject to any early withdrawal fees.

What to keep in mind when cashing out a 401(k) early

If you choose to make a withdrawal from your 401(k) before age 59 ½, there are some things you need to keep in mind. Chances are you're considering early withdrawal because you need money right away. An early withdrawal decreases the amount you will receive, so it's important to understand exactly what cashing out your 401(k) early will cost you, both in the short and long run.

The IRS will impose a 10% withdrawal fee

Because your 401(k) is a retirement fund and receives special tax privileges, the IRS imposes a 10% fee for cashing out early. This is meant to discourage you from using the money before you reach retirement age.

It will be counted as taxable income

In addition to the early withdrawal fee, there are taxes on cashing out a 401(k) that you need to be aware of. The government treats 401(k) withdrawals as taxable income, and 20% will automatically be withheld to cover federal taxes. You could end up getting some of this back as a tax refund, but it will depend on your particular financial circumstances. Also, you won't see the refund until the following year.

The mandatory federal tax withholding combined with the IRS's 10% penalty for cashing out means that you will automatically lose 30% from your distribution if you cash out early. If you make a withdrawal of $10,000, for instance, you'll only receive about $7,000.

The extra income you receive from the withdrawal could also move you into a higher tax bracket, meaning that a portion of what you've made, including the 401(k) withdrawal, could be taxed at a higher rate.

You'll have less of a retirement fund saved up

If you're not on the verge of retiring, it's easy to forget that making a 401(k) early withdrawal not only penalizes you now but also takes money away from your retirement funds. And you aren't just losing the amount you withdraw, you're also losing the money you would have earned on the withdrawn funds.

When you contribute to a 401(k), you have the option of investing them in the stock market. When your funds earn interest through these investments, the principal amount in your 401(k) continues to increase over time. Higher principals earn more interest, which you can then reinvest for even more gains. This is known as compounding interest and is how your retirement fund contributions grow until you make your first withdrawal.

For instance, if you make an early withdrawal of $10,000 at age 35, you will be losing out on more than just the $10,000 withdrawal amount come retirement. During the last decade, the average rete of return for 401(k)s was 9.5%. If your 401(k) averages a more conservative 8% return, by age 65, that $10,000 you withdrew could have grown to over $100,000 thanks to compounding interest.

You can use a compound interest calculator to learn how much that early withdrawal will truly be hurting your retirement savings. You can also look at your next 401(k) statement to see your estimated monthly distributions once you reach retirement age based on your current 401(k) investments.

Possible exceptions to the 10% penalty

In most instances, you have to wait until you're 59 ½ years old to avoid paying the IRS's early withdrawal fee. There are some exceptions to this rule, however.

For example, if you're between the ages of 55 and 59 ½ and lose your job for any reason, including voluntarily resigning, you can begin withdrawing from your 401(k) early without incurring a penalty fee.

The IRS also allows for penalty-free hardship withdrawals in some instances, such as preventing foreclosure on a primary home or burial expenses after a death. Each plan has slightly different rules regarding hardship withdrawals and what qualifies as an emergency situation, so you'll need to speak to your employer to find out if your circumstances qualify.

There are several other key exceptions for early withdrawal from a 401(k):

Permanent disability

Becoming totally and permanently disabled exempts you from the 401(k) early withdrawal penalty. In order to claim this exemption, you'll need documentation from your doctor stating that you are permanently unable to work due to a physical or mental disability. In addition, you'll need to file the IRS form 5329 when completing your income taxes.

Death

If you die, the beneficiary of your 401(k) can withdraw the funds even if you hadn't yet reached retirement age. If your spouse is the beneficiary, they can choose to cash out or roll the funds into another account. Any beneficiary other than a spouse will have to withdraw the funds during the first year after your death.

Repaying debt owed to the IRS

If you have unpaid taxes from previous years and refuse to pay, the IRS has the authority to levy your property. This means they can seize your personal property to repay the debt. Personal property can be physical assets such as your house or car, wages, rental income or money from your bank accounts and retirement funds.

If the IRS seizes money from your 401(k) to pay off your debt, they will take what is needed to cover the amount you owe. The amount that is levied is exempt from the 10% early withdrawal penalty regardless of your age at the time of the seizure.

Being called to active duty

If you're a military reservist who's been called to active duty, you may be able to withdraw from a 401(k) without incurring the IRS's 10% penalty fee. To qualify for this exception, the deployment must be at least 179 days long or indefinite.

As a military member, you can also repay the amount you withdrew for this purpose within two years of your deployment ending, even if this causes you to go over your annual contribution limit.

This option is meant to provide relief for military families who often incur additional costs such as childcare expenses when the military member is away from home.

Covering unreimbursed medical expenses

You can pull money from your 401(k) to cover some medical expenses without incurring an early withdrawal penalty. To qualify for a penalty-free withdrawal:

• The medical expenses cannot be covered by insurance.

• You, your spouse or a qualified dependent must be the recipient of the medical care.

• The expense must be in excess of 10% of your adjusted gross income.

If you must pull from your 401(k) to cover a medical expense that does not meet the above criteria, the withdrawal will be subject to the IRS's 10% fee.

Alternatives to cashing out a 401(k)

If you're in a dire financial situation where you need money right away, consider alternatives to cashing out your 401(k) early. Even if you're covered under an exemption, removing money from your retirement funds will diminish your retirement savings and hurt you in the future.

Here are alternatives you might want to consider before cashing out early:

Opt for a 401(k) loan

You can choose to take out a loan from your 401(k) account with the understanding that you must pay it back fully within five years. The exact amount you can take out as a loan will depend on the details of your employer's plan but is usually limited to 50% of your total funds or $50,000.

Keep in mind that, like any loan, you'll be responsible for paying back interest in addition to the principal amount you borrowed. You'll need to make four equal loan payments each year until you've repaid the full amount.

A loan is a better option than cashing out if you're confident that you'll be able to repay the money within five years and before retirement or leaving your job. If you do leave your employer before repaying the loan, the amount you owe will be considered a distribution and will be reduced from the amount of your 401(k).

You can speak to your human resources department or an employee financial advisor to learn the specifics of your 401(k) plan's loan limits and repayment details.

Convert to an IRA

If you're contemplating cashing out a 401(k) after leaving a job, consider converting it to an IRA instead. You can roll over your funds into an IRA, or individual retirement account, without paying income taxes or a penalty fee and you won't lose any money out of your retirement savings.

Once you transfer your funds to an IRA, you can choose what stocks and funds you'd like to invest your money in. The management fees for an IRA are usually quite low, often lower than those of a 401(k).

Another benefit of an IRA is that you can make contributions to it. This allows you to continue to save for your retirement. And if you believe you'll need to withdraw money early, you can convert your traditional IRA to a Roth IRA which makes it easier to withdraw contributions early without paying a penalty fee.

If you're considering cashing out a 401(k) to buy a house, moving it to an IRA is a better choice. You'll be able to withdraw up to $10,000 toward the purchase of a first home without having to pay a penalty fee.

Is cashing out a 401(k) early the best move to make?

Because of current market conditions and economic uncertainty, withdrawing from your 401(k) early might seem like an enticing option. However, keep in mind that maintaining or increasing your 401(k) savings rate is the best way to prepare for retirement. Withdrawing funds before the age of 59 ½ may put your financial future in further jeopardy.

Cashing out your 401(k) early should always be a last resort. There may be situations where doing so is necessary, but be sure to exhaust all other options first.

Using funds in your retirement accounts to pay off debt will often end up costing you more in the long run. Before cashing out or taking a loan against your 401(k), be sure you understand all of the fees for withdrawing early so you're not surprised by the reduced amount you receive. Also, know in advance how cashing out your 401(k) will affect your tax return.

If you ultimately decide that cashing out early is the best option in your circumstances, talk to your employer or plan administrator to learn how to make an early withdrawal. Always withdraw the lowest amount you can to preserve your retirement savings.