How to Cash Out a 401(k)
Posted by Frank Gogol in Investing | Updated on August 27, 2022
The 401(k) plan is a retirement savings plan that is sponsored by your employer. Whenever you earn your monthly pay, part of that money goes into your 401(k) plan, 401(a) plan, or whatever package you get – to be accessed when you finally decide to retire.
Still, there might come a time when you might need to tap into your 401(k) plan as you are in dire need of some urgent money and have run out of savings. Many people do so without understanding the consequences. So, this article will deal with how to cash out a 401(k) plan appropriately.
Table of Contents
Eligibility for Cashing a 401(k) Plan
In the event that you are still under the employment of the company that is paying for your 401(k), you won’t be eligible for cashing out your 401(k) plan. The only exceptions to this would be if the plan, in particular, allows for a 401(k) loan, an in-service withdrawal, or a hardship withdrawal.
One piece of advice would be to avoid taking out a 401(k) loan as much as you can. The cash you have in your 401(k) needs to be given as much time as you can in order to grow. The loan is also required to be paid back with interest, so you’ll just end up losing money in the long run.
If you are no longer under the employment of the companies that sponsor your 401(k) plan, then you are indeed eligible to get the money. You can either cash it out, or you may roll it over through an IRA.
If you choose the rollover instead of the cash-out, then you will not have to pay any penalty or income taxes. Rollovers aren’t taxable transactions – not if you do it correctly. If you roll your 401(k) plan over into another plan, then the IRS does not see this as cashing out.
401(k) Loan Option
An option for cashing out a 401(k) while under the employment of your sponsoring company would be to get a 401(k) loan. This way, you won’t be losing your investment portion and gains, like it usually happens with a typical withdrawal.
Instead of withdrawing indefinitely, a 401(k) loan is a better option because you will be taking out the money and have the repayments deducted from your paycheck. However, you will have to check with the terms of the plan, to see if they allow them and make you eligible.
Hardship Withdrawal Option
In the event of an emergency, the hardship withdrawal may be taken out without you having to deal with penalties. These hardship withdrawals make sense when you come across economic emergencies, such as paying medical bills, college fees, or funding the down payment for your first home. That being said, while you don’t have to pay penalties, you’ll still have to pay income tax.
Hardship withdrawals can only be given from an elective deferral account if the person meets the following conditions:
- They need the money for heavy yet immediate financial issues.
- They limit the withdrawal only to the necessary amount needed to satisfy the financial issue, bringing proof of it.
If it turns out that you are eligible, you need to provide the paperwork that was asked of you. These documents will depend on your employer, as well as the reason why you are making the withdrawal in the first place.
Once you have submitted all of the documents, you will receive a check with the sum – with the hope that you won’t be required to pay a penalty. Sometimes, what you see as an emergency may not look the same to them, in which case you will have to pay a 10% penalty.
Occasionally, if you leave the place of employment or you try to make the withdrawal in the year after you turn 55, you might not be required to pay the 10% penalty. There are other ways to avoid that penalty, in which case you should do some research.
Substantially Equal Period Payments
Substantially equal period payments (or 72(t) SEPPs) can also be a good option to rely on when you need to cash out some money from your 401(k), but without paying the penalty fee. These withdrawals cannot be done if you are still working for the employer that sponsors your 401(k) plan, but if you get the funds out through an IRA, then you can make these withdrawals at any time you want.
If you need money in the short term, the SEPP may not be an ideal choice to go for. Once you start making payments for this kind of withdrawal, you can expect to have to pay for at least five years on it, or until you hit 59 and a half – whichever comes first.
If you don’t make these payments, the penalty for early withdrawal will apply, and you’ll also be asked to pay interest on the deferred penalties over the past couple of tax years.
There are two exceptions to this rule. The first exception is when the taxpayer dies, allowing for beneficiary withdrawals. The second exception is when the taxpayer becomes disabled permanently.
The withdrawal and payments will be calculated through methods approved by the IRS. You may get fixed annuitization, fixed amortization, or required minimum distribution. Each will allow you to withdraw different amounts, so you can choose just the one you need.
Early Withdrawal From a 401(k) FAQs
When it comes to 401(k) plans, you might have some lingering questions concerning early withdrawals. Here you have some of the most important ones, along with their answers.
Can you make an early withdrawal from your 401(k) plan?
Yes, you can make an early withdrawal – but just because you can, it doesn’t mean that you should. Cashing out from your 401(k) plan early can come with several financial consequences such as loss of interest growth or penalties. This is why it’s not recommended to cash out the 401(k) until you are at least 59 years old.
Can you withdraw from 401(k) plans without having to pay a penalty?
Yes, you can if you need to pay for college tuition, economic hardship, or you need a down payment for your first home. Also, if you need to cover costs for adoption or birth, you may cash out up to $5,000 without being subjected to taxes.
How much will I be required to pay in taxes for a 401(k) withdrawal?
When you make a withdrawal, you need to pay normal income tax. As an account owner, you have a total of 3 years to pay back the taxes that you owe.
What exactly qualifies as a ‘hardship withdrawal’?
Financial withdrawals are permitted when a certain event is in a dire need of financial aid. For example, emergency medical procedures fall into this category. The amount that you borrow must be used entirely to cover said hardship. In these circumstances, you won’t have to pay any early withdrawal penalties, but you’ll still have to deal with the taxes.
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Making a withdrawal from your 401(k) is usually possible, but even if you are given the opportunity, you will have to think twice about it. Cashing the money out is easy, but you should be sure you understand the financial consequences.
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