Investors use 401(k) plans as a way to contribute pre-tax earnings, often along with employer contributions, to help fund a more secure retirement. However, you may be tempted to access the funds early. For example, when you change jobs, you have the option of cashing out a 401(k) to move it to another plan, invest elsewhere or use in other ways. Anything other than a direct rollover, however, risks severe tax penalties and places your retirement at risk.
IRS Takes Its Cut
Cashing out your 401(k) doesn’t mean you’ll be able to access your entire balance. Your employer is required to withhold 20 percent for the Internal Revenue Service off the top. When you fail to place it in a qualified retirement account within 60 days, it’s taxed as ordinary income at the federal and state level. You’ll also pay a 10 percent penalty if you’re younger than 59 1/2 in most cases. Moreover, the added income may push you into a higher tax bracket, increasing the percentage of income you’ll pay in taxes for all your earnings.
Less Funds for Retirement
Withdrawing funds from your 401(k) doesn’t just cost you money now; it means you’ll have less later. Money taken out of a 401(k) isn’t achieving the compounded earnings essential to building up your balance over time. The opportunity cost that comes with removing the funds can have severe impact on what’s available when you’re no longer able to work. In addition, taking out funds when you're later into your career gives you less time to catch up and get your balance back up.
Some situations allow you to cash out your 401(k) without paying the penalty. If you have medical expenses that exceed 10 percent of your adjusted gross income, you can withdraw funds from your retirement plan without penalty to pay them, as long as you do so in the year the expenses were incurred. If you’re totally and permanently disabled, and you have enough evidence to convince the Internal Revenue Service of this, you likewise can access the funds. If you’re 55 and left your job, you’re allowed to access the funds early as well.
Roll Over Carefully
If you’re rolling over the 401(k) into a new retirement plan, directly transfer the funds to the new employer’s 401(k) or into an individual retirement account. If you cash out and perform an indirect rollover -- meaning the distribution check is made out to you and you then deposit it into the new qualifying account -- your employer still has to withhold 20 percent, which becomes a taxable distribution unless you make up that amount out of pocket in the new account. If you delay more than 60 days before completing the rollover, the entire amount becomes taxable income.