Occasionally, workers may find it desirable to liquidate their 401(k) balances and use the money for something else. Whether you must cash out your 401(k) for living expenses, medical expenses, or to start a business, that decision can have long term consequences for your retirement security. Cashing out a 401(k) prior to age 59-and-a-half could cost you income taxes on the withdrawal, plus an additional 10 percent penalty, unless the withdrawal was for certain specific purposes, such as the down payment on a house, education, to pay medical bills or if the account owner has become disabled.
Plan Rules
Because the 401(k) is an employer-sponsored plan, the first place to check is your plan rules. These vary, since plan sponsors have a good deal of latitude in how they structure their programs. Some plans prohibit distributions to workers who are still employed at the company. Others give you the option of taking a 401(k) loan instead of a taxable withdrawal.
Taxation of 401(k) Distributions
By law, your 401(k) custodian must withhold 20 percent of any distribution to you and forward it to the IRS for estate tax. Additionally, you will receive a 1099 from the fund company, and your distribution will be reported to the IRS. Unless you rolled your 401(k) balance over to an IRA within 60 days of the withdrawal, your entire withdrawal will be charged ordinary income tax in that same year. By taking your entire distribution at once, you could push your distribution into a higher tax bracket than you would be in if you took your balance out gradually over a number of years. The IRS also charges a 10 percent penalty except for certain hardship distributions
Hardship Distrubutions
To avoid the 10 percent penalty on withdrawals prior to age 59-and-a-half, the withdrawal must be a hardship distribution. The IRS defines these as withdrawals for the following reasons: disability, down payment on a home of up to $10,000 for yourself or a relative, to pay medical expenses, to pay for medical insurance or if you take the withdrawal in substantially equal periodic payments as defined under Section 72(t) of the tax code.
Considerations
When you withdraw money from a 401(k) plan, not only are you paying taxes and penalties in the current year, you are also giving up the benefit of years of future compounding. Because of limitations on the amount you can contribute to a 401(k) or IRA, you may not be able to replace that money in a similar tax-advantaged account. Additionally, 401(k) assets enjoy substantial protection against the claims of creditors. These assets could potentially become exposed to judgments once you take them out of a 401(k). IRA assets enjoy similar protection, but only up to $1 million, under federal law. State law occasionally extends this protection to greater amounts.
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