How Many Taxes Are Due When You Cash Out a 401(k)?

The Internal Revenue Service only allows you to cash out a 401(k) plan in the event that you have turned 59 1/2 years old, suffer a permanent disability or leave your job. However, you will still be liable for applicable taxes and potential 401(k) early withdrawal penalties on your cash-out.

401(k) Cash Out and Federal Tax

The money that you cash out from your 401(k) plan counts as taxable income on your federal income taxes for the year you take the lump sum distribution. This can lead to you being bumped into a higher income tax bracket and paying more in taxes than if you had spaced out your distributions over a longer period of time. For example, if you are single in 2018 and you have more than $38,701 but less than $82,500 of taxable income, you would fall in the 22 percent tax bracket. However, if your income was $80,000 and you cashed out $50,000 from your 401(k) plan, you would fall in the 24 percent tax bracket.

State Taxes on 401(k)

State income taxes also apply to the amount of your 401(k) plan cash-out. The state income tax rates will be lower than the federal income tax rates, but will still take a bit out of your distribution. The rates vary from state to state and, like the federal government, many states use progressive tax rates so a large cash-out could push you into a higher income tax bracket.

Early Withdrawal Penalties

If you cash out your 401(k) plan before you reach age 59 1/2, you have to pay an additional 10 percent as an early 401(k) withdrawal penalty when you file your taxes. However, the IRS permits you can cash out your 401(k) plan as soon as you leave employment. For example, if you work for a company until you are 40 and then leave your job, you can cash out your 401(k) plan whether you are fired or leave voluntarily. However, a $200,000 lump sum distribution taken before age 59 1/2 would result in a $20,000 income tax penalty.

There are exceptions to these early withdrawal penalty rules, fortunately. If you leave the employer with which you have your 401(k) (called "separation from service") during or after the year you turn 55, there is no early withdrawal penalty (at age 50 if you are a public safety employee of a state government or a political subdivision of a state government, and you have a governmental defined benefit plan).

Alternatives To Cashing Out

You can leave the money in your 401(k) plan and take periodic distributions as you need the money instead of cashing out. This allows you to continue to allow the money to grow tax-deferred. In addition, you may be able to avoid higher income tax rates by taking smaller distributions each year. If you leave your employer, you may not be able to leave the money in your 401(k) plan with your employer. If you do not need to access the funds immediately, you can roll the money into a traditional IRA with no tax consequences. After you reach age 70 1/2, however, you will generally be required to take minimum distributions from your 401(k) or standard IRA. If you have a Roth IRA, there are usually no minimum distribution requirements until after you die.

2018 Tax Law Changes

The overall policies around 401(k) cash out tax didn't change for 2018, and the 10 percent penalty remains on the books for many early withdrawals. But overall, tax rates went down, meaning you may owe less if you cash out a 401(k) or similar account in 2018 rather than in previous years.