If you run into a financial emergency, your retirement plans might be your last source of funding. The rules for cashing out vary depending on your type of plan. For example, IRAs are much easier to cash out than employer plans. Often when you cash out a retirement plan early, you must pay penalties on top of income taxes.
Traditional IRAs allow you to take your money and run any time you want. But, if you're not yet 59 1/2 years old, it's a non-qualified withdrawal. Non-qualified withdrawals are a double whammy because you pay a 10 percent early withdrawal penalty on the taxable portion of the withdrawal on top of income taxes. Except in cases where you've made nondeductible contributions, your entire traditional IRA withdrawal is taxable. If you did make nondeductible contributions, you get a prorated portion of the withdrawal out tax-free and penalty-free.
Roth IRAs are equally easy to cash out and more favorable for taxes. Unless your account is five years old and you are 59 1/2, you cannot take a qualified distribution, but even when you're not taking a qualified withdrawal, you get your contributions out tax-free and without penalty, because you've already paid taxes on that money. Only after you've drained your Roth IRA of the contributions do you start taking out earnings, which get hit with the double whammy of income taxes and tax penalties.
401(k)s and 403(b)s
If you have a 401(k) plan or 403(b) plan, it's not nearly as easy to cash out as IRAs. If you're not 59 1/2, you can only take a distribution if you become permanently disabled, leave the company or take a hardship distribution. You can also take a qualified reservist distribution from a 403(b) plan. Hardship distributions allow you to take out enough money to cover an immediate and heavy financial need when you have no other source of funds, such as for funeral expenses or mortgage payments to avoid foreclosure. However, not all plans allow hardship distributions. Like IRAs, a 10 percent early withdrawal penalty applies to early distributions, including hardship withdrawals, unless an exception applies.
If you qualify for an exception, you can avoid the 10 percent early withdrawal penalty on cashing out your retirement plan. But, you're still stuck footing the bill for the taxes. Suffering a permanent disability, taking distributions from an inherited account as a beneficiary and qualified reservist distributions always exempt you from the penalty. For IRAs, you can also avoid the penalty for higher education expenses and up to $10,000 for a first-time home purchase.
- Internal Revenue Service: Publication 590 -- Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: General Distribution Rules
- Internal Revenue Service: Topic 558 - Tax on Early Distributions from Retirement Plans, Other Than IRAs
- Internal Revenue Service: Publication 571 -- Tax-Sheltered Annuity Plans (403(b) Plans)
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