Your 401k contains cash for your golden years, but you may end up closing your account long before you quit work. You can close your account when you retire, change jobs and, in some instances, while still employed. When you terminate a 401k plan, though, you have to contend with taxes and penalties.
Both you and your employer can deposit money into your 401k. However, while your own contributions immediately belong to you, your employer's contributions must become vested. Vesting is a term used to describe the process through which employees gradually become entitled to certain benefits. Your employer may use a cliff vesting schedule, in which case you're entitled to your employer's 401k contributions after you've completed three years of service. Alternatively, your employer may use a graduated vesting schedule, in which case the money becomes vested at a rate of 20 percent per year after you've completed two years of service. When you close your 401k account, you lose any funds that have not been vested.
Like other retirement accounts, 401ks grow on a tax-deferred basis. This means you have to pay both state and federal income tax on your withdrawals. You also pay a 10 percent federal tax penalty if you make a withdrawal or close your account before reaching the age of 59 1/2. However, the penalty is not assessed if you make a withdrawal under certain conditions, such as after becoming disabled, or if you need the cash to cover non-reimbursed medical bills.
While most 401k plans are funded on a pre-tax basis, some plans include a provision for after-tax or Roth contributions. You don't have to pay any taxes on Roth 401k withdrawals as long as you hold the account for five years and until you've reached the age of 59 1/2. If you fail to meet one or both of these requirements, then you must pay ordinary income tax on your account earnings. Your earnings may also be subject to the 10 percent federal tax penalty if you're under the age of 59 1/2. Regardless of age, you get to access your principal without paying any tax.
You can avoid paying taxes and penalties on your 401k money if you roll the cash into an Individual Retirement Account (IRA). You can also move the funds from one 401k plan to a similar plan offered through your new employer. When you close your 401k, you have a 60-day window within which to roll the money into another tax-qualified retirement account. If you don't complete the rollover within this time frame, then you have to accept the cash as income and pay any applicable taxes and penalties.
Generally, you can't close out a 401k that's sponsored by your current employer. However, some firms allow you to close out a 401k and make an in-service withdrawal if you've reached the age of 59 1/2. You might opt to do this if your plan includes very few investment options, as you can broaden your horizons by rolling the cash into an IRA. If you're under the age of 59 1/2, you may have the option to roll your account earnings into another account, but you can't actually close out your 401k while still employed.
- Internal Revenue Service: 401(k) Resource Guide - Plan Sponsors - General Distribution Rules
- Internal Revenue Service: Retirement Plans FAQs on Designated Roth Accounts
- United States Department of Labor: What You Should Know About Your Retirement Plan
- Putnam Investments: Opportunity in 401(k) non-hardship withdrawals
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