Your company-sponsored 401(k) or individual retirement account may have a large balance, but be careful about using it as your personal piggy bank. Early withdrawals come with a big tax hit -- and in most cases, penalties if you pull money out before retirement age. The Internal Revenue Service immediately withholds 20 percent for federal taxes, and if you cash out before retirement age, an additional 10 percent is pulled out as a penalty. According to Consumer Reports, almost 45 percent of workers cash out their 401(k) accounts when they change jobs.
Taxes and Penalties
If your retirement account has a balance of $50,000 -- which is less than the national average of $75,000 for 401(k) accounts, as reported by Fidelity -- expect to lose $10,000 in mandatory tax withholding before you even see the check. In addition, a 10 percent penalty -- in this case $5,000 -- is also taken out if you withdraw early. Immediately, your $50,000 check shrinks to $35,000 when you receive it.
On top of the 30 percent in taxes and penalties, the IRS treats your 401(k) or IRA cash-out as additional income. While the 20 percent withholding may cover the difference, nothing is certain until you figure your taxes at the end of the year. If you're in a higher tax bracket, you may need to make up the difference.
While there's no way around the 20 percent tax withholding, under some circumstances you may be able to skip the 10 percent penalty. For example, if you have medical expenses of more than 7.5 percent of your gross income, 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. An IRA gives you more flexibility. You can withdraw penalty-free to go to school or pay health insurance premiums, so you may find it easier to withdraw money from a traditional IRA than an 401(k).
If your former employer pays matching funds and you're not fully vested, 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 transfer the money into the new account. You may also open a traditional IRA account and roll the 401(k) money there. Direct rollovers can be done without tax or penalties. The only real exception here is rolling the money into a Roth IRA. All taxes on a Roth are paid up front, so expect 20 percent to be withheld during the transfer.
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