Here at Capitalize, we’re all about the 401(k) rollover. We want Americans to have greater control over their retirement savings, and rolling over old 401(k) retirement plans to an Individual Retirement Account (or IRA) can be one of the best ways to maintain that control.
But what if you want to access your money now? Here, we’ll answer some of the common questions related to cashing out your 401(k).
“Cashing out” your 401(k) is just another way of saying “taking money out” of your retirement plan. When you take money out of your employer’s plan, it’s yours to spend, pur in a savings account, invest, or use in whatever way you see fit. This is not to say you’ll be free of taxes and early distribution penalties, though — we’ll explore this later.
Note that cashing out your 401(k) and rolling over your 401(k) are two entirely different processes with entirely different tax and financial planning consequences. Rolling over your retirement account, if done properly, should result in no tax due; cashing out your 401(k) will typically result in a tax penalty and/or early withdrawal penalties depending on your age, tax bracket, and a variety of other factors, which is why it’s commonly used as a last resort.
If you opt to cash out your 401(k), you’ll need to contact your 401(k) plan provider and have them send you the money either electronically or via paper check. This process can take anywhere from a few days to a few weeks. In either case, you should receive the money within a reasonable amount of time after requesting it.
There are some advantages to cashing out your 401(k), namely:
Depending on how badly you need the money, cashing out your 401(k) will provide valuable liquidity. Sometimes the need to meet an urgent expense can override the need to save for retirement, though it’s important to exercise caution if you choose to do this.
Let’s face it — a 401(k) plan is designed to help you save for retirement, which for many people is more than a decade away. You’ll be hit with taxes and penalties if you want to access your money early, but at least the remaining money will be all yours.
You’ll see — very quickly — why cashing out may not be the best idea. Some considerations include:
When you put money into a 401(k), you receive a tax deduction in the current year. When you remove it, you’ll pay ordinary income tax, or “taxable income”, on any distributed amount. You’re going to owe ta whether you take money out as a 30-year-old or a 60-year-old, so make sure to account for this as part of your tax planning. Note that unlike traditional 401(k)s, Roth 401(k) contributions are made after tax, so once you’re eligible, you can make withdrawals tax-free.
Unless you’re facing one of the IRS-defined hardships — and you’re below the penalty-free withdrawal age 59 ½ — you will likely be liable for an additional 10% early withdrawal penalty. These costs can add up quickly and can take a huge bite out of your retirement savings, so make sure you really need the money before you opt to cash out. Consider discussing penalties and tax implications with your financial advisor, who will likely look at the impact on your tax bracket.
Compound interest is another way of saying “interest on interest” — it results in exponential account growth over time. By cashing out your 401(k) early, you’ll be giving up somewhere around 30% of your balance to taxes and penalties. This will substantially reduce your asset base and limit the degree to which your account can grow via compound interest in the future. Note that if you cease to make additional contributions, you may miss out on taking advantage of any employer match offerings you may have.
As mentioned earlier, your 401(k) is intended as a retirement savings vehicle. Typically, when the IRS earmarks a certain account for a certain purpose, you’ll get the best results when you use the account as intended. Yes, you can access 401(k) money early, and you’ll certainly pay for the privilege, but you’ll also get a far better result if you view your 401(k) money as a way to cover costs in retirement.
Withdrawals from pre-tax 401(k)s are taxed as ordinary income — in other words, they’re taxed at your highest marginal tax rate and considered gross income. Note that this is the same rate at which your job or freelance income is taxed.
Ordinary income tax is higher than long-term capital gains tax, which is the tax charged on any realized stock gains after you’ve held the stock for a year or longer in a taxable account.
If you have a Roth 401(k) or Roth IRA, you won’t pay ordinary income tax when you withdraw money, as you already paid tax on this money when you made contributions to the account. You will still be liable for the 10% early withdrawal penalty, however, if you’re below the retirement age of 59 ½.
Cashing out your 401(k) after leaving a job is an easy process with only a few steps:
Important note: Your 401(k) plan administrator will likely withhold 20% of the withdrawal amount for federal income tax. This is to ensure the IRS receives its share of your withdrawal. The procedure may vary here, so ask about tax withholdings when you contact the plan administrator and ask them if there are any additional taxes you should be aware of.
In most circumstances, a financial advisor will suggest it’s best to avoid cashing out your 401(k). If you do, you’ll be on the hook for taxes and/or penalties, and you’ll severely cut into the growth potential of a valuable tax-deferred retirement account.
However, if you do find yourself up against an immediate and emergent expense (usually known as hardship withdrawals), you always have the option of cashing out early to regain access to your money. There are some nuances to hardship distribution penalties, which can include events ranging from medical expenses and medical bills, funeral expenses, foreclosure prevention, or heavy financial needs, so it’s important to discuss with your financial advisor before you make any financial decisions. While it’s not the financially optimal decision, it may be the necessary one should you find yourself in any one of these positions.
Again, cashing out your 401(k) is not the same as rolling over your 401(k) account balance, which is, in many cases, a good idea. In fact, a forgotten 401(k) can have a seriously detrimental effect on your retirement savings (i.e., it can add years to your working career). Be sure to know the location of each retirement account you own and take active steps to optimize their respective positions.
Cashing out a 401(k) comes with many disadvantages, so if you need emergency access to money, you may want to consider one of these alternatives.
If you haven’t yet left your job, a 401(k) loan may be an option. Similar to cashing out your 401(k), a 401(k) loan against your retirement fund can get you access to the money you need, but it keeps your account open, and technically, you’re paying yourself back for the loan. However, you’ll need to be cautious with 401(k) loans. If you leave your company, you could be on the hook for paying back the balance due within 60 days, and failure to do so could mean a hefty tax burden.
There are many low-interest loan options available, whether it’s an unsecured personal loan, a balance transfer credit card, or a home equity loan. In an emergency, it can be tempting to act quickly, but you’ll need to carefully consider options before taking on loan debt. If you have a great credit score or are willing to put up collateral to secure the loan, you could receive a favorable interest rate. Before taking out any loan, many personal finance experts recommend to be sure you have a plan in place to repay the money you owe.
This one is easy to say but harder to put into practice. Yet if you’re in a financial situation where you’re considering cashing out your 401(k) retirement funds, you may be willing to put in the time to earn a bit of extra money. If you have the opportunity to sign up for overtime at work, that’s a great way to earn more at a rate that might be higher than what you typically earn. Outside of full-time employment, you can explore various side hustles or gig work, whether online or in person.
Cashing out a 401(k) can be a serious financial decision to make. It’s important to understand how you may be impacted by taxes and penalties, so be sure to speak to a trusted personal financial advisor before you make up your mind. They may be able to help you understand your specific applicability for a hardship withdrawal, and in turn, help you avoid a costly mistake.
As an alternative, a 401(k) rollover can be a better option for your retirement savings if you want to continue your retirement strategy momentum and take advantage of compounding interest. Capitalize can help you locate old 401(k)s and choose an IRA to consolidate them into – all while managing the entire 401(k) rollover process for you, for free.