Employer 401k plans allow employees to save for retirement using paycheck deductions, employer contributions and investment interest. Unlike some other types of retirement investments, 401k holders do not sell their investments outright. Instead they cash out their plans to receive distributions either before, or during, retirement. In each case, receiving money from a 401k has tax implications for the plan holder.
Taxes on Lump Sums
401k plan holders who decide to cash out their entire plans and receive the full balance in cash must pay tax on the distributions they receive. The plan manager will submit a 1099-R form to the plan holder with information about taxable distributions and how to claim them on income taxes. A 401k holder who has been contributing to a plan for many years may be able to cash out the plans for a lump sum and claim long-term capital gains on a portion of the earnings, while claiming the rest as ordinary income. Others must claim the full amount as ordinary, taxable income.
If you cash out a 401k plan to put the money into another eligible retirement savings plan, such as a 403(b) plan or a 401k with a new employer, you will not need to pay taxes on the money you reinvest. However, if you roll over only a portion of your retirement savings, you'll need to pay taxes on the portion you receive as cash. The amount that rolls over is also your responsibility to report to the federal government when you file your next income tax return. The 1099-R form you receive will indicate the amount you cashed out, as well as how much (if any) of that amount is taxable.
Cashing out your 401k plan before reaching retirement age will subject you to an additional tax penalty. As of publication, anyone who receives distributions from a 401k before age 59-1/2, except in cases of severe financial hardship, must pay an additional 10-percent tax penalty on the distributions. This tax discourages workers from using their 401k plans for purposes other than saving for retirement.
Loss of Deferral
Losing the ability to defer taxes is another negative, though indirect, tax consequence of cashing out a 401k. One of the key benefits of a 401k is the fact that workers contribute income before taxes. They pay tax on that money, plus the interest it earns, when they receive it as a 401k distribution. If that happens during retirement, the 401k holder's income and tax rate are likely much lower, reducing total lifetime tax liability. Cashing out a 401k at any time eliminates these tax savings unless the money rolls over directly into another eligible, tax-deferred retirement plan.