In turbulent financial times, it's often tempting to pocket some extra money by cashing out a 401(k). It is true that if you have a 401(k) in your name, you can access the funds if you are going through some kind of qualifying emergency, like a serious medical emergency or a possible foreclosure. However, before you grab money from your 401(k), be sure you understand the serious taxes and penalties associated with early 401(k) distributions.
Federal 401(k) Guidelines
A 401(k) account owner must be 59 1/2 years old to avoid penalties and taxes associated with cashing out a 401(k) early, according to IRS rules.
Taxes and Penalties
Cashing out a 401(k) early is expensive. Any early distributions incur a penalty fee equal to 10 percent of the 401(k) balance. In addition, you must pay taxes on the distribution by including the amount of the distribution in your annual income figure when you determine your taxes for that year. After taxes and penalties, some individuals end up pocketing only 60 percent of their 401(k) balance.
To withdraw money from your 401(k) before age 59 1/2, you must typically qualify for a hardship distribution. Declaring a hardship won't exempt you from the taxes and penalties, but it at least might give you access to the remainder of your funds. Every 401(k) plan is set up a little differently, but to qualify for a hardship withdrawal you typically must have an immediate financial need that cannot be satisfied by owned assets, other income sources or the care of family members. Most hardship distributions are related to a medical need, home ownership, tuition or the death of a family member. The documentation required for a hardship distribution varies. Check with your 401(k) provider for documentation requirements.
Avoiding Unnecessary Penalties
Avoiding distributions prior to age 59 1/2 is a surefire way to maximize your 401(k) earnings. If you receive an unavoidable distribution, due to change in employer or the termination of an employer's 401(k) plan, you can roll the distribution over to a personal IRA plan without penalty. Check with your bank to determine its exact requirements for rolling over a distribution.
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