Most retirement accounts, such as a traditional individual retirement account or a company-sponsored 401(k) plan, are funded with pre-tax dollars. The earnings grow tax-deferred. If you cash out these plans before you reach retirement age, you'll face ordinary income tax. You will also have to pay an early distribution penalty in most cases. For workers in the top tax brackets, you may lose more than 50 percent of your distribution to taxes and penalties.
TL;DR (Too Long; Didn't Read)
The retirement income you withdrawal early will be taxable at your normal income level. Taking out the money early, however, will also cause you to incur penalties.
Ordinary Income Tax
Regardless of when you cash in your retirement account, you'll face ordinary income tax on your distribution. The only exception is if you take a qualified withdrawal from a Roth IRA, which is funded with after-tax money. As of 2018, the top federal income tax bracket is 37 percent. California has the highest state tax bracket at 12.3 percent.
If you're a high earner in the state of California, cashing in your retirement plan could therefore cost you as much as 49.3 percent in federal and state taxes alone. A $100,000 distribution could shrink to just $50,700, and that's before any penalties are applied.
Early Withdrawal Penalties
If you take money out of a retirement account before age 59 ½, you'll typically face a 10 percent early withdrawal penalty. There are certain allowable exceptions to the early withdrawal penalty.
For example, if you have medical expenses of more than 10 percent of your gross income (7.5 percent if you are age 65 or older), you may be allowed to withdraw without penalty. Other hardships, such as permanent disability or a court order in a divorce, may protect you from the penalty.
If you have an IRA, you can withdraw penalty-free to go to school or to pay health insurance premiums while unemployed, but this is not true in the case of a 401(k). If you don't qualify for any of these exceptions, you'll get hit with the 10 percent penalty.
If you are not yet vested in part of your 401(k) balance, you may want to leave your 401(k) where it is if the employer allows it. Vesting may continue after you're gone, and there's little sense in turning away free money.
If you land a job with a 401(k) in its benefit package, you can roll over the money and avoid any taxes or penalties. The same is true if you roll over your 401(k) balance into a traditional IRA, since direct rollovers are not considered distributions and are therefore tax-free and penalty-free. If you convert to a Roth IRA, your rollover would be fully taxable, since Roths are funded with after-tax money. You could still avoid the 10 percent early withdrawal penalty, however.
John Csiszar served as a financial adviser for over 18 years, both for a global wirehouse and at his own investment advisory firm, earning a Certified Financial Planner designation along the way. He now works as a writing and editing contractor for private clients, with thousands of online articles to his credit, along with five educational books written for young adults.