A 401(k) is, of course, meant to fund your retirement. However, circumstances may arise under which you'll want to cash out the account. Proceed with caution. Internal Revenue Service regulations are designed to discourage early 401(k) withdrawals. Cashing out an account before retirement age can yield you as little as 60 percent of the plan's value.
The IRS did create a few loopholes in the otherwise starched and solid fabric of 401k withdrawal rules. A hardship distribution is penalty-free as long as it is taken to satisfy "an immediate and heavy financial need," according to the IRS. Among such heavy needs are medical care, homebuying expenses and higher education expenses for the coming year. You can also take a hardship withdrawal to cover the rent or mortgage if you are threatened with eviction or foreclosure. Funeral expenses are also considered a heavy need. You can only withdraw your own contributions, the amounts that were deducted from your paycheck. You cannot take out earnings or matching contributions from your employer.
Early Withdrawal Penalty
If you are not in hardship circumstances, money withdrawn from a 401(k) before age 59 1/2 is considered an early withdrawal. You have to report the amount of the withdrawal on your tax return for the year. In addition to paying ordinary income tax on the distribution, the IRS levies a 10 percent penalty. Keep in mind, too, that the withdrawal might propel you into a higher tax bracket for the year. If the distribution shifts you into the 35 percent tax bracket, you'll end up with only 55 percent of what is in the account.
If you are forced to cash out your 401(k) because you leave the company, for example, ask for a direct transfer of the plan funds to a traditional IRA. Rolling over the funds this way allows you to sidestep tax liability. If you have an existing IRA, you may want to open a separate IRA to accept the rollover funds.
Plan Terminated by Employer
If your employer, for whatever reason, puts an end to the 401(k) plan and does not offer a defined contribution plan in its place, you can cheerfully accept a check for the full amount of the 401(k) balance without fear of tax liability. You then have 60 days from the day you receive the check to roll the funds into another employer-sponsored plan or into a traditional IRA.