How to cash out a 401(k) — and why you almost never should

Woman and man sitting together on the couch, going through their finances and looking up how to cash out a 401(k)Image: Woman and man sitting together on the couch, going through their finances and looking up how to cash out a 401(k)

In a Nutshell

If you have a 401(k) from a past job, you may be able to get a cash payout. But the significant tax impact of cashing out a 401(k) means it’s rarely a good idea.
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If you have a 401(k) from a past job, you may be tempted to cash it out. But just because you can doesn’t necessarily mean you should.

You may consider cashing out an old 401(k) for a number of reasons — to cover an unexpected expense, fund a big purchase or just to make a clean break from a past employer.

But the tax impact of withdrawing money from a 401(k) can be significant, especially if you’ll be subject to early withdrawal penalties in addition to federal income taxes. Plus, when you take money out of a 401(k), those funds are no longer helping you grow your retirement savings.

Let’s look at some details about cashing out a 401(k), including reasons why it should only be considered as a last resort.

Can I cash out my 401(k)?

When you cash out a financial account, including a 401(k) retirement account, you basically withdraw all the money in the account.

Because 401(k)s are employer-sponsored retirement accounts, withdrawal rules can vary a bit. But generally, you can only withdraw money from a 401(k) — including cashing it out — after you’ve left the employer that sponsored the account.

Of course, there are exceptions. If you become disabled, experience a financial hardship or reach age 59½, you may be able to take money from your 401(k) without penalty. But you’ll still have to pay federal income tax on the amount you withdrew, which the IRS refers to as a distribution.

How can I cash out a 401(k)?

Provided you’re eligible to make a 401(k) withdrawal, you’ll need to follow the plan administrator’s rules for requesting one. You may be required to have an online account, speak to a representative directly or complete some necessary paperwork to make the withdrawal.

Contact your plan administrator for guidance.

How long does it take to cash out a 401(k)?

Taking money out of a retirement account is a process. The Consumer Financial Protection Bureau notes that it could take several weeks to complete a withdrawal.

How long it takes to get your money will depend on the plan administrator — each one could have its own rules and time frame for making distributions. When you submit your withdrawal request, you may be able to ask the plan administrator for an ETA on the money.

Taxes and penalties: The cost of cashing out

One of the many reasons 401(k)s make attractive retirement savings vehicles is that you don’t have to pay tax on the money you contribute to them. Instead, you pay tax when you take money out of a 401(k).

If you wait until you retire to withdraw money, you could be in a lower tax bracket than when you were working, so you’d likely pay less tax on the money.

But if you make an early withdrawal (one taken before you’re 59½), IRS rules generally require the plan administrator to withhold 20% of the distribution for federal income taxes. Plus, your early withdrawal could be subject to an additional 10% penalty.

Here’s an example of how taxes and penalties could eat into a cashout amount.

And the tax impact may not end at 20%, since withdrawals are taxed as ordinary income. If your marginal tax rate is higher than 20%, you could end up owing more tax when you file your federal income tax return for the year in which you made the withdrawal.

What are exceptions to the early withdrawal penalty?

While the 10% penalty generally applies if you take money out of a 401(k) early, the IRS allows some exceptions for financial hardship. If you meet all the qualifications, and your employer allows hardship withdrawals, you may be able to take a hardship distribution without penalty to cover certain expenses.

  • Medical care (for yourself, a spouse or a dependent) that would be allowed as a medical expense deduction, regardless of whether you actually take such a deduction
  • Costs directly related to buying a principal residence, excluding mortgage payments
  • Paying tuition and college expenses, including room and board, for yourself, a spouse, your children or other dependents
  • Making payments to prevent eviction from, or foreclosure, on your home
  • Funeral expenses
  • Expenses related to repairing damage to your home caused by a qualifying disaster

And, earlier in 2020, the federal government made provisions in the Coronavirus Aid, Relief and Economic Security Act to allow people affected by COVID-19 to draw on their retirement accounts, including 401(k)s. More on that here.

What are some alternatives to cashing out a 401(k)?

You have other options for what to do with money sitting in an old 401(k) — ones that, if done right, won’t leave you facing taxes and penalties.

If you need money: The 401(k) loan option

If you urgently need money and you’ve exhausted other options, you may be able to take a loan from a 401(k), provided the sponsoring employer permits loans. The IRS has some rules for how 401(k) loans can work.

  • You can borrow up to 50% of your vested balance up to a maximum of $50,000.
  • You have to repay the loan within five years, unless you used the money to buy your main home.
  • You must make regular, substantially equal payments, at least quarterly, over the repayment period.

If your loan meets all the above criteria, you won’t have to pay tax on the amount you borrowed.

The keep-it-growing option: Rollover to another retirement account

Maybe you don’t like the idea of leaving your retirement account with a past employer, or you have another retirement plan with investment options you like better. You can move the funds in your old 401(k) into another retirement account, such as an IRA or — if your current employer offers one — a new 401(k). This is called a rollover, and there are different kinds of rollovers.

With a direct rollover, the administrator of your old 401(k) transfers the money directly into your new eligible retirement plan. When you do a direct rollover, the administrator isn’t required to withhold 20% for taxes.

If you choose a 60-day rollover, the 401(k) funds get distributed to you, tax will be withheld and you have 60 days to put the money into a new retirement account. Here’s the catch: In order to avoid the 10% early withdrawal penalty, you’ll need to deposit the full amount you withdrew from the old plan into the new one, so you’ll have to use other funds to make up the amount withheld for taxes.

Bottom line

Cashing out an old 401(k) should be considered as a last option. Not only will you owe federal taxes on the amount you withdraw, you may also face state income taxes if you live in a state that has an individual income tax. With potential penalties, the inevitable tax impact and loss of future growth, you should never cash out a 401(k) without a compelling reason for doing so.

Explore alternatives, such as rollovers and a 401(k) loan. And if you must take money out of a retirement plan to deal with economic hardship caused by the pandemic, try to take advantage of the extra time to repay the withdrawal.

Relevant sources: IRS: 401(k) Resource Guide – Plan Sponsors – General Distribution Rules | Consumer Financial Protection Bureau: Considering an early retirement withdrawal? CARES Act rules and what you should know | IRS: 401(k) Plans | IRS Publication 575, Pension and Annuity Income (2019) | Coronavirus Aid, Relief and Economic Security (CARES) Act | IRS: 401(k) Resource Guide – Plan Participants – General Distribution Rules | IRS: Rollovers of Retirement Plan and IRA Distributions | FINRA: CARES Act 2020: Retirement Fund Access and Student Loan Relief | IRS: Coronavirus-related relief for retirement plans and IRAs questions and answers

About the author: With nearly 30 years of experience in media, marketing, public relations and journalism, Evelyn’s written about nearly everything — from newspaper accounts of salacious capital murder trials to whitepapers on what typ… Read more.