If you need to cash out your 401(k) early, you’ll pay a penalty unless you have a qualifying reason to do so. Being able to determine the exact amount of money you’ll lose if you take your funds early will help you decide if this is the best option for getting access to your money, or if you should search for other options.
What Does Early Mean?
The government offers tax benefits for retirement savings products like IRAs and 401(k) accounts to encourage people to save money to help them after they retire. If you decide to start using these tax-advantaged funds before you retire, you’ll have to pay a penalty since you’re now increasing the risk you won’t have enough money when you retire and you’ll need more government or charitable organization assistance. If you cash out your 401(k) before you reach age 59 1/2, you’ll not only pay taxes on the amount you withdraw, but you’ll also incur penalties, explains Bankrate.com.
How Much Will You Lose?
If you start taking money out of your 401(k) early, you’ll pay taxes of 20 percent of what you withdraw. So, if you take $20,000 out of your 401(k) before you reach 59 1/2, you’ll have $4,000 in taxes withheld and keep $16,000. This is not a penalty, but your tax withholding requirement. You might get some of this back in the form of a tax refund if your tax liability for the year turns out to be less than $4,000.
In terms of a penalty, you will pay a 10 percent amount for an early withdrawal based on your age and other factors, according to the IRS. In the example above, you’ll pay another $2,000. This means if you need $20,000, you’ll only end up with $14,000 in your pocket if you access your 401(k) early. This 10 percent is a permanent loss, regardless of your annual income tax liability that year.
You can also find certain cashing-out 401(k) penalties calculators online.
Don’t Forget Lost Interest
When you withdraw funds early from your 401(k), it’s going to reduce the amount of interest you earn, which you might have counted to your retirement “number,” or final goal. You’ll have to recalculate your projected number based on how much you have left in your 401(k) and how many years you plan on letting it ride before you finally start emptying it.
Exceptions for Cashing Out Early
You won’t pay the 10 percent penalty if you qualify for one of the exemptions the IRS provides for some people. If you leave your job (at age 55 for private-sector workers and age 50 for some public workers), you might be able to avoid the penalty. If you go through a divorce and split the 401(k) with your spouse, you might avoid the penalty. If you stop working and arrange to take the same amount until you are aged 59 1/2, you can avoid a penalty if you take approximately the same amount based on a specified number of years and your age.
You can also avoid penalties if you become disabled, transfer funds to a different qualifying retirement account, you had or adopted a child, you are paying an IRS fine or penalty for something else, you serve in the military and are called to active duty or you over-funded your account. You might qualify for other hardship exemptions, such as high medical bills, home purchase or repair-related costs, a death in the family or funding your or your kids’ college costs.
Because tax laws change frequently, it’s a good idea to meet with a qualified tax advisor or Certified Financial Planner to determine exactly what penalties you’ll pay in the year you plan on cashing out your 401(k) early. You can use an online calculator to estimate your state and federal taxes and penalties, but meeting with a professional will give you more peace of mind.
- 401(k)HelpCenter: Hardship Withdrawals Give Access to Your 401k Savings, but at a Cost
- Wells Fargo: 401(k) or Other Qualified Employer Sponsored Retirement Plan (QRP) Early Distribution Costs Calculator
- Bankrate: How To Withdraw Money From a 401(k) Early
- IRS.gov: Retirement Topics - Exceptions to Tax on Early Distributions
Steve Milano has written more than 1,000 pieces of personal finance and frugal living articles for dozens of websites, including Motley Fool, Zacks, Bankrate, Quickbooks, SmartyCents, Knew Money, Don't Waste Your Money and Credit Card Ideas, as well as his own websites.