Cashing Out a 401(k)
Whether you retire, change jobs, or find yourself in some sort of financial hardship, there are some considerations to keep in mind before cashing out a 401(k):
- Taxes – Cashing out your 401(k) typically requires an automatic federal tax withholding of 20% and if the account consists of 100% pre-tax contributions, then 100% of your plan withdrawal will be subject to ordinary income tax. For example, if you cash out a $100,000 401(k), most likely $20,000 will be automatically withheld for federal tax. You will net $80,000. Depending on your tax bracket, at tax-filing time, you may or may not get some of the previously withheld $20,000 back and if it was not enough to cover the federal tax due, you may actually owe more. In addition, depending on your state of residence, state tax may also be imposed.
- Penalties – If you withdraw funds from your 401(k) prior to attaining age 59 ½, you will be subject to a 10% early withdrawal penalty, in addition to income taxes. If in the example above, the individual withdrawing $100,000 from his/her 401(k) were not yet 59 ½, another $10,000 would be imposed in early withdrawal penalty, dropping the $80,000 net withdrawal to $70,000. The 10% penalty amount will be due at the time you file your tax return so you should remember to set these funds aside. Do remember that there are some exceptions to the 10% penalty such as death, disability, and extraordinary medical expenses. See this IRS link for more detail: Retirement Topics – Exceptions to Tax on Early Distributions.
- Rollover – If you cash out your 401(k), but then rollover any portion of it to an IRA within 60 days, you can avoid the above-mentioned taxes/penalties. Also, if you do not actually need the funds, always remember a direct rollover can be done to an IRA to avoid tax and penalty entirely.
- Loan – Your 401(k) plan may offer loan capabilities, which typically allow you to take up to (1.) the greater of $10,000 or 50% of your vested balance, or (2.) $50,000 – whichever is less. A loan allows you access to your 401(k) without the tax and penalty mentioned above; however, you must pay the loan back within a certain period (typically 5 years) with interest. There have been some changes to these rules because of the CARES Act passed in early 2020.
- Long-term impact on financial health – Cashing out your 401(k) at any time requires great consideration. You should discuss the pros and cons with a professional financial and/or tax advisor. Be sure you understand the consequences of your decision from a tax and penalty standpoint, as well as the long-term effect the withdrawal may have on your financial goals.
Rolling Over a 401(k)
Upon retirement or change of employer, you will need to decide what to do with your 401(k)/403(b) or other employer plan balance. Depending on the size of the account, you may be able to leave it in the former employer’s plan. Other options include transferring it into your new employer’s plan, completing a rollover to another company, or withdrawing the funds entirely.
There are a few things to consider when deciding how best to handle the funds in your retirement plan:
- Type of plan balance
- Timeframe for funds
- Investment Options
Type of plan balance: You will want to determine if your plan balance consists of only pre-tax dollars and employer match, only Roth or after-tax dollars with pre-tax employer match, or some combination of both. This is important to know should you decide to withdraw or roll funds over because there are certain rules involved with each. For example, a direct rollover of 100% pre-tax dollars and employer match dollars to an Individual Retirement Account (IRA) is considered a tax-free transaction. If your plan consists of some Roth or after-tax dollars and pre-tax employer match, you must be mindful of keeping the Roth/after-tax dollars in Roth ownership, while rolling the pre-tax dollars to a Traditional IRA – unless you are considering a conversion.
Fees: Typically, 401(k) plan fees are relatively low – but that is not always the case. You should determine what you are paying in fees within the 401(k) on an annual basis, including any advisor management fees or asset-based fees, plan/participant administrative or maintenance fees, and the approximate internal cost of the investments.
Penalties: Remember with certain plans, there may be penalties for certain types of withdrawals. If you withdraw monies from your retirement plan before age 59 ½, there is a 10% early withdrawal penalty. Also, if your plan is a SIMPLE IRA and it has not been open for 2 years from the date of initial funding, there is a 25% early withdrawal penalty. You should also be mindful of any vesting schedules. With some plans, your employer may have established that their contributions (like profit-sharing contributions) vest over a period of time, and should you leave the employer before you are fully vested, you must forfeit the unvested portion.
Taxes: Taxes are always an important consideration when deciding how to withdraw or rollover a retirement asset. As mentioned above, a pre-tax 401(k) rollover to a pre-tax Traditional IRA would be considered a tax-free rollover; however, if you were to withdraw a portion of your pre-tax 401(k) balance, it would be subject to income taxation at your ordinary income tax rate (and possibly penalty as mentioned above). If you decide to convert some portion of pre-tax IRA assets to Roth, the tax consequences would be very similar. It’s important to talk to a tax advisor before making decisions on withdrawing funds.
Timeframe for funds: Deciding when you need to draw from your retirement plan assets to supplement other sources of income is another consideration. Be mindful of your timeframe and be sure not to roll the funds into a product with upfront surrender charges or commissions if you have a shorter timeframe.
Investment Options: One final consideration is the breadth of investment options available within the current plan. If the investment options are limited, you may benefit from transferring the funds to your new employer’s plan or an investment advisor where you will have a wider selection to suit your needs.
When you decide what you want to do with your plan’s funds, you should call the plan provider and ask them what the process is for a rollover/transfer/withdrawal. Oftentimes, the plan will allow the distribution to be done over the phone or through secure email access or participant login. Some plans will require signatures on their distribution documents. During this process, you will indicate your request and also be able to withhold taxes from your distribution, if tax will apply.
Deciding what to do with retirement plan funds at retirement or change of employer can be a big decision. The above items are some of the most important things to consider. Keep in mind that the help of a trusted tax advisor and/or financial planner is invaluable when it comes to making these types of decisions.
Check out the previous pieces in our series on retirement accounts, “The Main Differences Between 401(k)s and IRAs” and “Everything You Need to Know About Self-Directed IRAs and Non-Deductible IRAs”.
To discuss this content further or to ask any financial-life question you may have, we encourage you to reach out to us at 724.942.2639 or schedule a FREE/no-obligation time to chat with an advisor at your convenience.
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