The Internal Revenue Service only allows you to cash out a 401k 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 early withdrawal penalties on your cash-out.
Federal Income Taxes
The money that you cash out from your 401k 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 2010 you have $82,400 of taxable income, you would fall in the 25 percent tax bracket. However, if you cashed out $50,000 from your 401k plan, you would fall in the 28 percent tax bracket.
State Income Taxes
State income taxes also apply to the amount of your 401k 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 Penalty
If you cash out your 401k plan before you reach age 59 1/2, you have to pay an additional 10 percent as an early withdrawal penalty when you file your taxes. However, the IRS permits you can cash out your 401k 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 401k 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.
Alternatives to Cashing Out
You can leave the money in your 401k 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 401k 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.