Acceptable Reasons to Cash Out a 401(k)

Cashing out a 401(k) can set your life's financial planning back. One of the keys to building a successful retirement is to start as early as possible, since the longer money sits, the longer it has to grow. However, there are times that you might have to tap into your 401(k) and give up those benefits.

Cashing out your 401(k) has three big problems. The first is that the money is gone from your savings. The second is that you have to pay federal and, depending on where you live, state income taxes on it. The third is that you usually have to pay a 10 percent penalty as well. This means that you don't get a lot out of what you take out of your account. For instance, you could pull $2,000 out of your 401(k) and only end up with $1,400. First, you might pay $300 for federal income tax if you're in the 15 percent tax bracket. Next, you'll pay $100 in state income tax, assuming that you live in a state with a 5 percent rate. Finally, you'll pay $200 more for the 10 percent penalty, leaving you with just $1,400.

The Internal Revenue Service will let you cash out your 401(k) without imposing a penalty if you use the money for certain approved purposes. You'll still pay income tax, and you'll still lose the money for your savings, but won't get hit with the extra 10 percent penalty. Allowed reasons include paying medical expenses that are more than 10 percent of your adjusted gross income and having the IRS take money out of the account through a levy to pay off back taxes.

Ultimately, if you're in financial trouble, a 401(k) hardship withdrawal might be the only way that you can tap into the money you need to get out of it. Hardship withdrawals are at your employer's discretion and if you're allowed to take them, you can do it for such things as buying a house, paying tuition, preventing foreclosure on your house, repairing your house and paying funeral expenses. Remember, though, that you only get a portion of the money you pull out, since much of it goes to taxes and penalties. Also, once the money is gone, you won't be able to tap it again. You might be able to avoid pulling out your money by taking a loan against it. If your employer allows 401(k) loans, you can borrow from your account tax-free as long as you pay the loan back to yourself with interest within five years.

If you change jobs, you might get an opportunity to cash out your 401(k). Taking the money and putting it in your pocket will cause the IRS to sock you with taxes and penalties. However, if you roll the money over to another 401(k) or to your own individual retirement account, you can keep it working for you and not owe any taxes on it. Setting the rollover up as a direct one, where the money goes from account to account without you ever touching it, makes the whole process much easier.

The 401(k) account's key benefit is tax-deferral. This means that you put money in tax-free now so that you have more money working for you later. When you pull money out in retirement, though, you end up paying taxes on everything. If your tax rate is higher when you retire than it is now, you even could end up paying more. With that in mind, it could make good sense to pay taxes to pull money out of a 401(k) now to put it into an account, like a Roth IRA or Roth 401(k), that is tax-free when you withdraw the funds in retirement.