Information & Advice on 401(k) Cash-Out Penalties

I cashed out my 401(k) and they took 60% and told me the rest had to go back to the employer. This doesn't sound right to me.

I have a 401(k) account with a previous employer. I never contributed because I did not know it existed until I left that job. I cashed it out to pay off debts and they took 60% and told me the rest had to go back to the employer. This doesn't sound right to me. Help!

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Bill's Answer
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  • Congress permits two types of hardship distributions.
  • File a Form 5329 to report the tax on early distributions.
  • Your plan administrator will send you a Form 1099-R.

You state in your question that you never made contributions to your 401(k) account. Employers only match based on contributions of the employees. Therefore, if you did not contribute then it is likely that neither did your employer. Either your employer did not create an 401(k) for you and instead enrolled you in a private pension plan, or if you had a 401(k) account and was not aware of it, the administrator miscalculated the penalty and taxes for your distribution.

We will discuss 401(k) distributions in a moment. Generally, however, unless you qualify for hardship distributions from a 401k plan, it is very expensive to liquidate 401k funds, and therefore, if you are looking to solve a debt problem you may want to look elsewhere.

If you have outstanding debts that you are struggling with, get a no-cost, no obligation analysis of your debt options from a pre-screened specialist, click to see if you qualify: Free Debt Relief Quote.

Now onto 401(k) distributions, penalties and solutions for you.

401(k) Distributions

In general, if you withdraw money from a traditional individual retirement account such as a 401(k) or other qualified retirement plan before you turn age 59½, you are subject to penalty of 10%. The taxable amount is also included in your taxable income. This 10% tax is in addition to regular income taxes. You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including your retirement withdrawal from your taxable income.

What this means is that if you withdraw $10,000, you may only end up with $6,000 (or less) in your pocket. Some withdrawals can be made without penalty, but these usually require a true financial hardship.

See the IRS document 401(k) Resource Guide - Plan Participants - General Distribution Rules for more information on distributions.

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Cashing-out a 401(k) Tax-Free

Let us say you leave an employer, and your former employer’s 401(k) administrator wants to close your account and give you a distribution. If you accept the distribution and deposit the check into your usual checking or savings account, you are liable for significant taxes and penalties.

To avoid the taxes and penalties, roll the funds from the 401(k) into an IRA, or your new employer’s 401(k). Your new employer’s plan administrator will be able to assist you if you want to go this route. If you want to set up an IRA account, your financial institution will be more than happy to set up an IRA for you. See the IRS document "Publication 590 (2008), Individual Retirement Arrangements (IRAs)" for more information on IRAs, and for more information on rollovers, see the IRS document "Topic 413 - Rollovers from Retirement Plans."

Regarding the cashing-out penalties, rules vary from company to company, it becomes difficult to calculate the penalties. Contact the plan administrator at your previous employer to find out the actual modalities of your cash out (early withdrawal), and an accounting of the taxes and the penalties they charged you.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com

282 Comments

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  • UA
    Aug, 2014
    up
    very informative
    Votes

  • MR
    Jun, 2011
    Michelle
    My husband has a 401K thru his work that currently has $18800 in it. We really don't want to have anything tied to his company as they seem to constantly lose our money. We also have a car note that is $14000 and roughly $16000 in outstanding debt. We are wondering if it would be a good idea to cash out my husbands 401K, pay off the car, sell it (hopefully for $12500 - it's kbb value), take the $12500 put that plus an additional $3500 saved up to pay off the additional $16000 debt we have. Then start from scratch a new Roth IRA for him - putting in $200 he normally would have put in the 401K, plus an additional $600 a month (extra money we'll have after car and additional debt is paid off), making it $800 a month towards his new IRA to get him caught back up - with still having about $760 extra a month that we weren't used to due to paying down the debt. Otherwise, according to our car loan - it will still be 4 years before it's paid off ($450/month payment), and according to the debt management company we're with it'll be 2 years before that's paid off ($910 a month....HELP!
    0 Votes

    • BA
      Jun, 2011
      Bill
      In general, I dislike the idea of taking a distribution from an 401(k) to retire debt. Consider a 401(k) loan, which may accomplish all you want without penalty.

      I will assume the employee/owner of the 401(k) is age 59½ or less. If you account for and factor in the 10% penalty tax, and the increased income tax you will pay for the distribution, your idea is fine if you are disciplined and put the $800 per month you mentioned in a traditional or Roth IRA.

      Many people leave the default investment choice for their 401(k)s. Check to see if other investment options are available.
      1 Votes

    • MR
      Jun, 2011
      Michelle
      Hi Bill, Yes I'm sorry, my husband and I are 25 and 27 years old respectively. Which is why we thought this might be a rational decision since we are still young enough to "reimburse" ourselves and rebuild a new retirement for my husband from scratch. We currently do not have any children - so no expense there right now. We do however, plan to try soon. Also, we have a $1076.67 mortgage and roughly $900 in utilities (this includes cable/internet/netflicks and the usual). Our monthly take home income is roughly $4900 (we make roughly $40K each). Hope this additional info helps to give us more of an idea if this is a good way to go or not. We figure getting debt free would add to our credit scores (which are currently in the mid good range) and also would alleviate stress from our lives (good for our health) and overall make us be able to live more comfortably. Let me know if there's any info you need that I haven't provided. Could you give me an estimate on what the penalty and the taxes for the cash out of his 401k would be (it says surrender val is 18864.14 and there's a notation of free withdrawal available of $3372.61 - don't know what that means?). Thanks so much!
      0 Votes

    • BA
      Jun, 2011
      Bill
      Consult with the 401(k) administrator to learn if your spouse is fully vested. "Free withdrawal" may be the amount available for a loan, but that is a guess.

      Regarding the penalties and taxes, I am loath to make such an estimation for readers because I never know enough about the reader's tax situation, such as if they use the standard or itemized deduction, and so on. Consult with a tax preparer, or complete a dummy tax return to estimate your 2011 tax liability.
      1 Votes

    • MR
      Jun, 2011
      Michelle
      Okay thank you very much again for the information Bill, I do appreciate your time and input.
      0 Votes

    • EM
      Jul, 2011
      Eric
      On March 3, 2011 I was fired from Wal*Mart after 8 years of service. They consider you to be fully vested after 7 years. My 401(K) was around $14,000. They gave me the 10% penalty because I'm only 27 and asked if I wanted the taxes taken out as well (Merrill Lynch) and i said yes. I'm assuming this was the other 20% that everyone's referring to. They cut me a check for around ~$9,800. My mother works for a credit union so I've been getting "advice" all around me *eye roll.* Should I put to the side some 20% of that money to pay for my taxes THIS COMING YEAR? I do *crosses his fingers* plan on getting a job very very soon. And I understand I'd be taxed on Jan-Feb. from Wal*Mart PLUS wherever else I'd be working. I guess another question is will this ALSO include my $9,800 that I received after they taxed me? So in theory i get taxed twice? I hope this is not as round about as it sounds and I can get a good answer. I'm planning for vacation.
      3 Votes

    • BA
      Jul, 2011
      Bill
      You are not taxed twice. You paid a 10% penalty of $1,400. You had 20%, $2,800, withheld, leaving you with 70% of the $14,000, the $9,800. When you file your taxes, you list the $2,800 that was withheld as already paid. If you overpaid, you will get a refund, if you underpaid, then you will owe more. It all depends on your tax bracket and how much you have withheld from other sources of income.
      1 Votes

    • TB
      Jul, 2011
      Toni
      I am a 46 yr old, between jobs, and have accumulated significant credit card debt in order to cover expenses over the last few years. Also I had taken a $25,000 loan against my 401k a year or two ago and the balance is around $15k. I have $115,000 remaining in my 401k with my previous employer. What I'd really like to do is take out enough money to cover my $40,000 credit card debt and roll over the remaining balance in my 401k to my new employer's 401k (I'll be starting with them in two weeks). I know it's not the best idea to take money from my 401k because of the penalty and tax implications, but my credit card rates are high and I can't seem to make headway due to paying the finance charges. It would be such a relief to be without these high credit card balances ... I'd appreciate your advice on the best way to take care of this debt and roll the bulk of my 401k money into a new account. Any idea re tax+penalty percentage? Also, any advice on how to pay the 401k loan balance I already have?
      0 Votes

    • BA
      Jul, 2011
      Bill
      Your question is variation on the old relative rates of return problems students see in business school. Sit down with a calculator and run the numbers:
      • Credit cards: How much will it cost for you to continue on your present path?
      • 401(k): How much will it cost for you take a distribution? Remember, you have the 10% penalty tax plus the impact on your income.
      • 401(k) loan: Ask your program administrator what eligibility you may have for a loan against your 401(k), and the cost.

      Your answer will be in black and white after you run the numbers.

      0 Votes

    • MS
      Aug, 2011
      Melinda
      I am 27 years old and recently divorced. I am getting half of his 401K which at the moment is about $31,000. That puts me at approximately $15,500 of the money. I have taken on a lot of credit card debt, student loans, and medical loans until I thought I could get on my feet. However, I am not getting that way and just want to make sure I can continue to raise the 2 children and such on my own. Do I cash in on this 401K and start a new one of my own very soon? Or do I use this as a starter base? If I cash in what am I looking at for penalties and such if I claim a hardship?
      0 Votes

    • BA
      Aug, 2011
      Bill
      How your divorce settlement is structured and the laws of your state are keys to whom is obligated to penalties, if they are necessary. Check with your lawyer and the plan administrator.

      Rolling the $15,500 you mentioned into an IRA is your most prudent action because it has no tax consequences. After the $15,500 is rolled into an IRA, you can take distributions from that account, but you will pay a 10% penalty tax, plus the distribution is considered income, and must be declared as such on your income tax return.
      If you do NOT roll over the funds into a retirement account, you will have to pay taxes on what you take out, based on your tax bracket for the year. If your income is low and you are in a low bracket, you will pay less taxes than if you take out money in a year where you are in a higher bracket. Only you can decide if it is more important to pay the taxes and have cash in hand to stabilize your family's finances or if you should not pay any taxes and roll over the entire amount.
      0 Votes

  • DC
    May, 2011
    Dana
    I have a 401K from a job I quit in early 2006. I didn't touch it after I left and as of right now there is approx $8000 in it. I have another 401K from my last job with about $18000 in it that I plan to roll into my current employers 401K in January of 2012 (when I'm eligible). I am 30 years old and need approx $5000 for a down payment on a house in the fall of this year. I understand penalties and accept them, but I need to know how to proceed so I can get the money and pay the taxes at the same time. How do I start this process? Thank you!!
    0 Votes

    • BA
      May, 2011
      Bill
      Call your 401(k) administrator, and consider a loan instead of a distribution.
      3 Votes

  • PV
    May, 2011
    Pips
    I may lose my job. I was wondering if state unemployment runs out, my savings runs out, and I still haven't found a job I will need to look at my Roth 401k (Taxes already paid on it) to pay my mortgage. This looks like I would at this point be able to fall under the 401k hardship clause since this would push me into foreclosure. I would be able to pull money out without any penalty, correct?
    0 Votes

  • GH
    May, 2011
    gerrod
    hi i am 38 years old and i am thinking about taking a loan against my 401k to buy a investment property.i will own the property outright. the ROI is about 6 years. is it smart to do this or should i just leave the money in my 401k. the property is a positive cash flow ( every month that its rented of course ) my job is very secure thank you !!!
    0 Votes

    • BA
      May, 2011
      Bill
      For starters, you need to factor in the 10% penalty for early withdrawal and the state and federal taxes that will be due. Depending on your tax bracket, you should figure on losing about 30-40% of what you withdraw, which is quite the hit. Once you have that figure, you need to consider how good a deal you are getting on the property. Is it worthwhile, even after the taxes and penalties? Your question also alluded to the fact that it will produce income when it is rented. Being a landlord has its risks. How long could you cover the mortgage (if any) and the upkeep on the rental, if the renters leave or damage the property?

      In general, I am against taking money out of retirement accounts. However, if the deal is too good to pass up, it can make sense. It is not clear to me what the actual figures are, though you did state that you expect a return on your investment in six years. The greater the outlay, the greater the risk. Six years to recoup is compelling and worth serious consideration. Just make sure to consider all the pros and cons and be certain to budget enough to cover all the taxes that will be due in April of the year after you take the withdrawal.
      0 Votes

    • GH
      May, 2011
      gerrod
      Hello again !! In response to your post there is no penalty for taking a loan,no taxes and i have 15 years to pay back the loan . I will pay back the loan much faster because the money i make off the property will go directly to the loan until its paid off. the total monthly cost is about 250 a month hoa, taxes and insurance.i know rental property is risky and is why i am asking the question should i leave the money in my 401k but to me this property could be a extra cash flow per month until the day i sell the property because i will own it and not have a mortgage payment due each month. thank you for your time
      3 Votes