You know the goal of your 401(k) plan is to save. But while you’ve been working hard to contribute part of your salary, life may get in the way. It may be dozens of unexpected medical bills or your house sustaining significant damage after a fire or tornado. When you don’t have enough funds on your own, you look for other immediate sources, including retirement money. However, cashing out your 401(k) is a heavy decision and shouldn’t be made lightly – but it may be necessary. Here’s what you need to know if you’re considering cashing out a 401(k). A financial advisor can help you organize your retirement savings and make sure you are set up to meet your financial goals.
Reasons for Cashing Out a 401(k)
There may be a few reasons why you would consider withdrawing from your 401(k). The simplest answer may be that you’re in retirement. You’re already past the minimum age requirement of 59 ½ and need to start supporting yourself with the funds. But your situation may be more complicated. You may have urgent medical expenses, burial costs or other immediate needs that you can’t avoid. In such cases, it may be necessary to cash out your 401(k) despite the financial consequences.
Before moving forward you should be clear on what your reasons are for cashing out your 401(k) and make sure that the costs of doing so are worth it to meet those reasons. If not, You should probably consider other ways to get access to the cash you need for your specific situation.
Eligible 401(k) Distributions
The IRS only recognizes certain situations where a 401(k) participant can make a qualified distribution from their account tax and penalty-free.
Typically, you must wait until you reach the age of 59.5 years old to withdraw funds without consequence. Otherwise, you face income tax and a 10% penalty on that money. And you must start taking distributions once you hit the age of 72. However, there are some special circumstances that allow you to take distributions.
There are also hardship distributions. Essentially, you must present a significant and immediate financial need to qualify. The funds must also be necessary to fulfill or address that financial need. According to the IRS, hardship distributions apply for:
- Medical care expenses incurred or needed by the employees themselves, their spouses or their dependents
- Costs directly tied to the buying of a primary residence (except mortgage payments)
- Tuition, educational expenses and room and board for the first 12 months of postsecondary education
- Money necessary to prevent eviction or foreclosure
- Funeral expenses
- Specific expenses relating to damage repairs on a primary residence
Additionally, some 401(k) plans allow you to borrow from the plan, usually up to 50% of the vested account balance with a maximum of $50,000 that must be repaid within five years. Also, you can roll over funds from your 401(k) plan into another retirement plan.
How to Cash Out Your 401(k)
The actual withdrawal process from your 401(k) will depend on your employer and your withdrawal method. There are typically three steps to cashing out your 401(k), which are:
- Check with your employer: First, you have to check with your employer or human resources (HR) department. You may want to withdraw early, but not every company allows its employees to cash before retirement. Even if they do, you should review the guidelines and requirements laid out in the plan documents. They should tell you which form of withdrawal you can take out and your eligibility.
- Notify your provider: After that, you can contact your 401(k) plan provider. The appropriate contact information should also be in your plan documents or statements. Once you do, you request they send all the necessary details and paperwork to cash out your plan. Your provider may be able to do this over the phone or through an online platform, though.
- Collect signatures and submit paperwork: You may need to collect signatures from specific personnel, such as representation from the HR department, to affirm you filed the correct paperwork. It also certifies that you chose to cash in early and may proceed with that.
The bigger the company, the longer this entire process may take. So, you might have to follow up with certain parties.
Considerations Before Cashing Out a 401(k)
You may feel like you need to cash out your 401(k), but there are consequences to this that can be expensive in the long run. Before withdrawing, consider these four potential costs and implications:
1. You Will Owe Taxes and Penalties
The IRS dictates that your age impacts your withdrawals from your 401(k). If you try to cash out the plan before the age of 59 1/2, the funds removed will face income tax. They will also be subject to a 10% penalty tax as well.
Withdrawing before the age of 59 ½ will probably result in 20% of the withdrawn amount being withheld. So, if you cash in $2,000, then you would only receive around $1,600. The remaining $400 goes to the IRS. The IRS sends out the 1099R tax form at the end of the year, which details these withheld funds.
During tax season, you must file your withdrawn cash as regular income. Based on your overall reported income and deductions, you may receive a refund or face additional tax.
2. Away with Creditor Protection
While your money grows in your 401(k), you keep it safe from creditors. Bankruptcy court cannot take money already in your 401(k). In addition, creditors cannot claim a legal right to the funds, otherwise known as filing a lien. Neither of these entities can force you to withdraw funds, either. So, in the event of bankruptcy, you already have a barrier protecting those funds.
With that in mind, it’s dangerous to crack into your 401(k) if you’re facing down bankruptcy. Even if you want to use the money to pay some of the debts, you still expose it to danger.
3. Getting The Funds May Take Time
Generally, it takes several weeks to actually cash in your 401(k) plan. Some companies, usually small ones, can even limit the number of distributions you can take out. They might only allow it once per year or once per quarter. These rules come in the form of your 401(k) summary plan document, which you and your company must follow.
But that means you may wait a significant amount of time, which can be dangerous if you’re facing a financial emergency.
4. You’ll Be Robbed of Future Retirement Savings
Cashing out your 401(k) does give you much more immediate access to funds than other alternatives. So, some do use it as a temporary fix for things like debt. For example, if you lose your job, money from the 401(k) can help cover living expenses while you job search. After you find one, you can hop back into saving instead.
But while it may fix an immediate need, it may harm your financial situation in the future. Cashing out now will cost you earnings and potential interest you would have otherwise earned. For instance, say you have $35,000 put away. Cashing those funds means you lose any future earnings on that amount. Even if you only contribute $5,000 annually and your employer matches that up to 5%, you’ll have around $499,445 waiting for you by the time you’re 66.
Keep in mind that you probably have a certain lifestyle you want to maintain in retirement, too. If you use your 401(k) now, you won’t have sufficient funds to support yourself. That will leave you scrambling to accomplish your retirement goals.
Saving for retirement is one of the main reasons everyday people work so hard. They put in the extra effort today so that they can live comfortably tomorrow. However, situations may arise where you believe you should tap into your nest egg early. While it may come with its costs, you might not feel like you have a choice. You should make sure you fully understand all the potential outcomes of you cashing out early and you may even want to speak with a professional to help you through the situation.
Tips for Getting Retirement Ready
- Retirement planning is complex and can be stressful. If you’re not sure what your vision looks like, consider speaking with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Social Security is another source of income you can expect during your senior years. While you shouldn’t depend on it, it can help cover smaller expenses during retirement. Find out the amount you’ll receive with our free Social Security calculator.
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