Cashing Out Your 401(K): All You Need to Know Before You Do It
8 MIN READ
Published September 29, 2023 | Updated October 28, 2023
If you’re dealing with emergency medical bills, job loss, or financial hardship, you may be wondering how to cancel your 401(k) and cash out. It’s possible to withdraw money from your 4019k) account before age 59 ½ if your employer allows it. Doing that is not advisable in most cases because it will cost you a lot in income tax and penalty and can deplete your retirement savings.
If you have no other alternatives available and decide to cash out, you’ll need to contact your employer, fill out the paperwork, and then you’ll be able to get access to the requested funds.
Should You Cancel Your 401(K) and Cash Out?
Typically, you won’t be able to cancel your 401(k) and cash out while you’re still working with the employer. You can suspend payroll deductions temporarily, but you won’t get any employer matches. If you find an old 401(k) from a previous employer, you’ll be able to cancel it and cash out, but you’ll have to pay taxes on the amount you withdraw and a penalty.
The IRS allows you to roll over the retirement funds in your 401(k) to a Roth IRA without taxes or penalties. You can also close your account without penalty if you’re at least 55 years old and leave your job, but you’ll still pay taxes on what you withdraw. Let’s take a closer look at different scenarios to explore whether it’s financially wise to withdraw from your retirement savings.
If you’re living paycheck to paycheck, it can be difficult to find funds to deal with medical emergencies, unexpected expenses, and mounting debt. Cashing out a 401(k) may seem like an attractive option, but it’s important to understand the implications of doing so.
If you’re facing financial hardship, you may be able to withdraw funds from your 401(k) before you turn 59 ½ years old without penalty. You’ll need to demonstrate heavy financial need and ensure that your employer’s plan offers this option. The following situations may qualify for penalty-free withdrawals:
- Funeral expenses
- Medical expenses
- Repairs to a primary residence due to floods, earthquakes, and fires
- Costs to prevent eviction or foreclosure
- Costs related to the purchase of a principal residence
- Education expenses and college tuition for up to 12 months
Job Loss or Unemployment
If you’ve recently lost your job or have experienced a reduction in hours, it may be difficult to keep up with your expenses. This is one of the main reasons why a lot of people may consider canceling their 401(k) and cashing out. If you have mounting debt on top of unemployment, it may be difficult to decide whether you should pay off debt or save for retirement.
If you’re experiencing prolonged unemployment, consider cashing out your 401(k) only after you’ve exhausted all other alternatives. Check to see if you qualify for unemployment benefits, speak to your lenders to find a solution or to get on a payment plan, scale back all expenses, and explore resources like food banks so you can avoid withdrawing any money from your 401(k).
Canceling a 401(k) and cashing out early can have a huge impact on your retirement savings. You’d lose out on the long-term investment growth, which can reduce your retirement income. This loss, along with the taxes and penalties, can negate any benefits you may get from getting access to funds early.
For example, if you had kept $25,000 in your 401(k) account instead of withdrawing it at a return interest rate of 5%, the future value could be $84,658 in 25 years. If you withdraw $25,000, you will lose out on earning $59,658 in interest over the years.
Seeking Professional Advice
Emergencies and financial hardship can happen to anyone, and you may be left with very few good financial options. But it’s always a good idea to speak to a 401(k) plan provider or a financial planner to understand your available options. They may be able to provide you with alternate solutions so you can avoid withdrawing funds from your 401(k). A professional can also check if you’re eligible for hardship distributions where you won’t have to pay the early withdrawal penalty.
Pros and Cons of Canceling and Cashing Out Your 401(K)
Before you withdraw funds from your 401(k) account, weigh the pros and cons carefully so you can make an informed decision.
- You’ll get immediate access to funds, and this can seem like a lifeline when you have an emergency.
- You’ll get some relief from financial stress.
- When you cancel your 401(k), you’ll remove the restrictions on the account and will have access to all your money in the account.
- You’ll have to pay an early withdrawal penalty.
- You’ll owe taxes on distributions.
- You’ll lose out on compound interest and growth on your balance.
- You’ll have additional stress about replacing the retirement account balance.
How to Cancel Your 401(K) and Cash Out
If you’ve decided to cancel your 401(k) and cash out and are fully aware of tax implications and penalties, here’s a quick guide on how to go about it.
Contacting Your Employer
Once you’ve determined how much money you’d like to cash out, contact the human resources department at your company to check if their plan allows this. You can also contact your plan administrator. You’ll need to complete the paperwork and request that your account be liquidated. Once your request is processed, the plan administrator will send a check for the amount you requested to your mailing address. Alternatively, they can also send the funds through wire or directly to your bank account.
Understand the tax implications of withdrawing money early from your 401(k). If you’re under the age of 59 ½, any amount you withdraw from a traditional 401(k) account is considered to be taxable income. Since the money in a 401(k) is tax-deferred, it will be subject to tax at your current tax bracket upon withdrawal. Additionally, you’ll pay a 10% penalty on the funds. When your plan administrator processes your request to withdraw money, they’ll usually withhold 20% of the amount for tax penalty. This is done to ensure that the IRS receives the tax amount.
Other than the taxes you’ll pay on the money you withdraw, you’ll also pay a 10% penalty on the amount you withdraw if you’re under the age of 59 ½. You may be exempt from this penalty only in a few cases, such as:
- You qualify for a hardship withdrawal.
- Your withdrawal qualifies as an exception to tax on early distributions based on IRS rules.
Alternatives to Cashing Out
Before you take money from your retirement account, consider these alternatives:
- Stop contributing to your 401(k) for a short amount of time so you can have some additional cash on hand.
- Reduce your expenses, get a roommate, and take on a side gig to increase your cash flow.
- Take out a personal loan or a home equity loan.
- Ask family or friends for a short-term loan to cover emergencies.
- Explore debt relief options to pay off some debts and free up more cash.
Can I Withdraw From My 401(K) Early?
If none of the alternatives discussed above work for you, you can withdraw from your 401(k) early as a last resort. Consult with a personal finance expert to understand the rules surrounding early withdrawals. While it’s possible to withdraw from your 401(k) early, it’s important that you understand the ramifications of doing so. Other than the early withdrawal penalty and the taxes, make sure you understand the true cost of withdrawing money from your account early since the money you withdraw will stop growing as soon as you take it out.
Brad Reichert, Founder and Managing Director of Reichert Asset Management LLC, explains this situation further. “Due to recent COVID-related legislation, tax-advantaged retirement plans like 401(k)’s, 403(b)’s, and other employer-sponsored plans now offer more flexibility in how and when you may access your retirement funds prior to your actual retirement,” Reichert shares.
“You might consider a 401(k) loan, where you pay yourself back the money you borrowed from your own retirement account,” says Reichert. “Or you may use the expanded exemptions from the pre-59-½ 10% penalty in certain cases related to medical expenses or recovery from natural disasters. It’s always a great idea to consult a licensed, experienced financial advisor or a CFP professional to learn about your options,” Reichert adds.
Getting Debt Relief Without Cashing Out Your 401(K)
If you’re thinking about cashing out your 401(k) because of debt, know that there are many other ways of dealing with debt. A credit counselor can review your budget, debts, and income and suggest ways of dealing with debt. They can also educate you about money management techniques so you can avoid debt in the future. Alternatively, you can also consolidate your debts or consider debt settlement if your debt is overwhelming and you can’t afford repayment.
Make the Smart Financial Decision
Deciding whether you should cancel your 401(k) and cash out is not an easy decision. Consult a tax advisor or a financial advisor to discuss your choices and compare the urgency of your immediate financial needs to the ability to achieve your retirement goals. There may be other alternatives available that would be better suited to your needs.