When you close out a 401k account, there are costs and penalties you might incur when funds are distributed to you, or when you file your taxes for the year in which you close out the account. Both types of costs are important to consider before you close the account. Unless you are rolling account funds over into a new account, or you qualify for IRS exemptions from tax or penalties, you might end up with significantly less money than you're expecting from the account closure.
You get to keep your own contributions that remain in your 401k account upon closure. However, if you close your 401k account and have separated from your employer, you will forfeit any matches your employer made to your account that you are not vested in. You will be able to keep any percentages of employer matches that you are vested in, even if the vesting percentage is less than 100. For example, if you are 20 percent vested in your employer matching contributions, you will keep the 20 percent but forfeit the remaining 80 percent.
When you close a 401k account, the proceeds you are entitled to receive are distributed to you. If you receive these funds directly and do not roll them over into another retirement account, then you will be subject to income tax on the amount distributed. Contributions you make to a regular 401k account are made pre-tax, which means you do not pay tax on the money used to initially fund the account. The IRS makes up for this by taxing you on the money when it is withdrawn. Investment brokerages routinely deduct a mandatory 10 percent to 20 percent from your distribution check to help pay for income taxes. However, your distribution is taxed at the same rate as all your other income from all sources in the year of distribution. If you have other sources of income, your income tax rate may be higher than 10 percent to 20 percent. Since your income tax is calculated based on the sum of all your income sources, the 10 percent to 20 percent deducted might not be enough to cover the tax actually due on your distribution.
Early Withdrawal Penalty
When you close your 401k account and receive a distribution of funds before reaching age 59 1/2, the IRS may impose a 10 percent early withdrawal penalty. This penalty is in addition to any income taxes due on your distribution. In limited circumstances, an early distribution is not subject to this penalty. For example, if you use your funds to pay for secondary education expenses, as a down payment on a first-time home purchase or for medical expenses while you're unemployed, then you are exempt from the early distribution penalty. Distributions you receive but rollover within 60 days of the distribution are also exempt.
Closing distributions of your own contributions from a Roth 401k account are not subject to income tax or early withdrawal penalties, unless your distribution also includes earnings on your contributions. Contributions you make to this type of 401k account are made with after-tax dollars, which means you have already paid tax on the money used to fund the account. However, earnings on your own contributions and employer-matches are not taxed up-front, so you may be subject to income tax and early withdrawal penalties on these amounts.
With a background in taxation and financial consulting, Alia Nikolakopulos has over a decade of experience resolving tax and finance issues. She is an IRS Enrolled Agent and has been a writer for these topics since 2010. Nikolakopulos is pursuing Bachelor of Science in accounting at the Metropolitan State University of Denver.