The 401(k) plan is a tax-deferred compensation plan that some employers provide to their workers, allowing them to invest pretax funds straight from their paycheck into an investment account. A 401(k) plan is meant to build savings for retirement, so its accompanying tax regulations encourage you to refrain from taking distributions, or cashing out your account fully, before retirement.
Ordinary Income Taxes
If you cash out your 401(k) at any stage of your life, you will have to pay ordinary income on the funds that you receive. In fact, when you withdraw funds from a 401(k), the employer who sponsors the plan must keep 20 percent of the funds reserved for the IRS. You then will receive a credit on that 20 percent when you file your federal income tax return. You also will face state income taxes on the withdrawn funds if you live in a state with an income tax.
In most cases, you will absorb a tax penalty in addition to ordinary income taxes if you cash out your 401(k) before you turn 59 1/2. The tax penalty for early withdrawals is 10 percent of the total funds withdrawn. However, if you are not 59 1/2 yet but you stopped working with the employer that sponsors the plan in or after the year that you turned 55 years old, then you can cash out your 401(k) without incurring the tax penalty, according to Fidelity.
The IRS allows for hardship withdrawals from 401(k) plans, enabling you to withdraw funds without facing the 10-percent tax penalty. According to the IRS, you must make the case that your need for the funds is "immediate and heavy." The withdrawal also cannot exceed your financial need without drawing a penalty. Cashing out a 401(k) likely would not meet hardship withdrawal requirements, because hardship distributions typically are limited to employees' contributions and do not include income earned in the account. Common qualifying hardship withdrawals include medical expenses, the purchase of a home, college tuition and burial or funeral expenses. You will not receive the hardship exception if you have other assets that you could use for the expenses.
Alternatives for Old Plans
If you switch jobs before retirement age, you do not have to cash out your 401(k). Many plans allows you to keep your money in the plan, though you will no longer be able to make contributions to the plan. You will depend on growth in the investments contained in the plan for your money to grow. Another option is to roll over your 401(k) funds into an IRA or a 401(k) with your new employer. You would not need to pay taxes on the funds that are rolled into a new plan as long as the transaction is completed within 60 days of withdrawing the funds.
Tom Gresham is a freelance writer and public relations specialist who has been writing professionally since 1999. His articles have appeared in "The Washington Post," "Virginia Magazine," "Vermont Magazine," "Adirondack Life" and the "Southern Arts Journal," among other publications. He graduated from the University of Virginia.