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JAN 16, 2013

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.

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401k questions and answers
Bill's Answer: Answered by Daniel Cohen

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.

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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

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Comments (281)


Michelle R.
Ameila, OH  |  June 15, 2011
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!
Bills.com
June 15, 2011
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.
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Michelle R.
Ameila, OH  |  June 15, 2011
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!
Bills.com
June 15, 2011
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.
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Michelle R.
Ameila, OH  |  June 15, 2011
Okay thank you very much again for the information Bill, I do appreciate your time and input.
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Eric M.
Lumberland, NY  |  July 21, 2011
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.
Bills.com
July 22, 2011
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.
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Toni B.
Glen Allen, VA  |  July 24, 2011
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?
Bills.com
July 25, 2011
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.

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Melinda S.
Red Wing, MN  |  August 01, 2011
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?
Bills.com
August 01, 2011
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.
Dana C.
Lakeline, OH  |  May 19, 2011
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!!
Bills.com
May 19, 2011
Call your 401(k) administrator, and consider a loan instead of a distribution.
Pips V.
May 17, 2011
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?
Bills.com
May 17, 2011
If you are in risk of foreclosure, you may take a hardship distribution from your IRA or 401(k). Read the IRS document the IRS document 401(k) Resource Guide - Plan Participants - General Distribution Rules to learn more about hardship distributions.
Gerrod H.
Mesa, AZ  |  May 12, 2011
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 !!!
Bills.com
May 12, 2011
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.
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Gerrod H.
Mesa, AZ  |  May 12, 2011
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
Andrew G.
Norristown Boroug, PA  |  May 01, 2011
I am 28 years old, married, with one child, homeowner, that has $5,000 in a previous 401k. I was laid off due to the economy at a very large company. My wife makes roughly $80,000/year. We are looking into selling our current home and move into a newer home by March of 2012. We wanted to take my $5000 of 401K money and apply it to the purchasing of the new home. How much will I be penalized for taking it out and should I wait until closer to the purchase time or take it out asap? Thanks is advance for your input
Bills.com
May 02, 2011
You will pay a 10% penalty tax for taking a distribution. Consult with your 401(k) administrator to learn what steps you must take to receive the distribution, and the timing for receiving the check.
Jimbow C.
Richmond, TX  |  April 28, 2011
ok i have $13,000 on my 401k i want to cash out i know i will get a penalty 20% plus 10% end of the year. i make 32k a year with tax withholding about $3,900 do you have any idea how much do i have to pay for my end of the year tax or do i still get some money in return?? last year i got some money back about $1.200 somthing. if i have to pay then how much do think you stimated do i have to pay? thanks
Bills.com
April 28, 2011
I cannot answer "How much do I owe or withhold?" tax questions because I never have enough information about the reader's financial situation. Consult with a tax preparer, who can review your tax and financial documents in person and give you a precise answer.
Lily S.
Newcastle, WA  |  April 27, 2011
I am 33 yrs old and lost my job over 5 months ago. I've been really depressed and have no money left as I've been living off my savings. I have about 4700.00 in a 401k and want to cash this out. I contemplated this long enough. When I spoke with the Plan adm, he said I could roll it over to an IRA but I need this money to eat and get by for the next month, yes it's that bad!...until I find a new job and who knows when that will happen?! I have 2k in expenses and that includes rent, bills, and not to mention food each month. After 20% + 10% in taxes and penalties, do you think it's worth it? It's a small amount and I still have a long ways till retirement. I am at my ends and have no other means. I would appreciate your insight and opinion and want to make the best decision but I need to eat! Thank you very much.
Bills.com
April 27, 2011
Let us say that for the sake of argument you take a distribution on your 401(k), pay your bills, buy groceries, and in a month or two you still do not have a job. What then? I am not saying you should or should not take a distribution on your 401(k), but what happens when that is gone? Pretend that scenario is playing out today, and then take action. Is it moving in with a sympathetic friend or relative? Applying for welfare? Selling your possessions?
Jay K.
Plainfield, IL  |  April 14, 2011
I'm planning on purchasing a new home and renting out my current residence. The new home will be my new primary residence. But to do so, I plan on cashing out my 401k for a down payment. But I'm still employed at the company that holds it. I'm in no financial distress but need the money for a down payment on the new house. The current real estate market is very attractive and I know over the next 3 to 5 years I'm make ten fold back in equity in the area im looking in. I have roughly 50k in there. What's the best way for me to go about this. I don't want to take a loan against it because I don't want to pay it back. Nonetheless, what's best for me to do???
Bills.com
April 14, 2011
See the IRS publication 401(k) Resource Guide - Plan Participants - General Distribution Rules to learn the general rules for a distribution. Also consult with your employer's 401(k) administrator to learn the specific rules for your plan.
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Evan S.
Pacifica, CA  |  April 21, 2011
Hello, I currently have a 401K plan worth approx 21K. I am 28 and am going back to school and want to get rid of my older student loans/credit card debt etc. upwards of 12K. I feel that buy cashing out my plan early and wiping my debt clean I will enable myself a better life now; even though I know this will be worth a lot more down the road. Would it be smart to cash out early in order to stop incurring years of high interest?
Bills.com
April 21, 2011
It is important to weigh all the pluses and minuses, before you pull money out of your retirement accounts. You will have to pay a 10% penalty ($2,800), plus pay taxes on the withdrawal. Figure on losing 40% of what you take out. If you were to pull out $12,000 to clear your debt, it will cost you around $4,800. Do you think that you would pay as much in interest as you stand to lose in taxes and penalties? Are your funds in your account tied to stocks that are at a low value now? If so, cashing out, as you mentioned, reduces your long term value significantly. I suggest you do the math. It likely depends on how high your interest rates. Another factor to consider is whether you will be able to maintain your monthly payment obligations when you go back to school. If not, then there is a greater value in clearing out the debt now. In general, however, I do not think it is a good idea to draw on retirement accounts unless no other good option exists.
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Evan S.
Pacifica, CA  |  April 21, 2011
I appreciate the timely response. The student loan I have is fairly low interest, however it is a long term graduated payment plan, so I will be paying it off for easily another 5-10 years. My credit cards vary from 20-25% APR with total debt being around 5K. I should also mention that my 401K is paid into fully by my employer; I never matched any of my own money into it. So I feel that even though I will incrue high taxes by pulling out early, it isn't money I originally invested so I'm not "losing" money the way I'm losing money with my debt. I believe that I will be reducing my bills annually by $3600-4000 so it seems that within a year or two I will have offset those taxes/penalties.
Frank L.
Sanford, ME  |  March 26, 2011
when you retire and cash out your 401k is the income tax rate the same as on your earned income before you retired?
Bills.com
March 26, 2011
No, your pre-retirement tax rate is irrelevant to the calculation of your present tax rate. See the IRS Publication 575: Pension and Annuity Income to learn more about calculating the tax on your 401(k) distribution.
Lily R.
Sanger, CA  |  March 08, 2011
I'm 29 years old, I was laid off and now I need my 401k for bills and living expenses. I know that if my 401k is paid directly to me they will deduct 20% plus a 10% early withdrawal penalty. My question is, if I roll it into an IRA and withdraw from there they will deduct 10% for federal tax and I would still pay the 10% early withdrawal penalty, is this a better option or will I some how still have to make up for the extra 10% I would have paid had I cashed out instead of doing a direct rollover?
Bills.com
March 08, 2011
Your tax obligation will be based on the dollar amount you have disbursed from your retirement account. The amount that is withheld by the retirement account plan administrator does not equate to what you owe, but is withheld to make it so that you will not have a huge shortfall when your taxes are due. If you only have 10% withheld, you may end up owing more when the taxes are due. I recommend that you speak with a tax professional to understand the implications of your potential choices, so you can make the best decision for yourself. Also, don't neglect to budget for state taxes, if you live in a state that has a state income tax.
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