Too many people cash out their 401k plan without fully understanding the consequences. This can be an expensive mistake. Here's what you need to know before you cash out.
First, Are You Eligible to Cash Out of Your 401k Plan?
If you are still employed by the company that sponsors your 401k plan then you will not be eligible to cash out of the plan. Instead, you can see if your plan offers either a 401k plan loan, or a 401k plan hardship withdrawal (not all 401k plans allow hardship withdrawals so you need to ask your plan administrator if your plan has this feature.)
If you are no longer employed by the company that sponsors your 401k plan, then you are eligible to get your money out of your 401k plan. You can cash out of the plan, or rollover your 401k plan balance to an IRA. If you choose to rollover your 401k plan instead of cashing out, then you will not have to pay taxes or penalty taxes: rollovers to IRAs are not taxable transactions if you do them the right way.
See 8 IRA Rollover Frequently Asked Questions to learn more.
The One Reason Why You May Not Want to Cash Out of Your 401k Plan – Creditor Protection
Money in a 401k plan is creditor protected, and it is protected from bankruptcy. It is foolish to cash out a 401k plan to pay down debt if it is likely you may end up filing bankruptcy. The bankruptcy court cannot touch your 401k plan and creditors cannot attach the assets in your 401k plan.
Taxes on Cashing Out of Your 401k Plan
If you must cash out of your 401k plan and you have not yet reached age 59 ½ then the dollar amount you cash out will be subject to ordinary income taxes and a 10% penalty tax.
If you are not yet age 59 ½ it is usually required that 20% in taxes is withheld from any balance that you cash in, so for every $1,000 you cash in, you would receive about $800. The other $200 would be sent to the IRS. At the end of the year the 401k plan will send you a tax form called a 1099R that shows the amount of taxes withheld on your behalf.
When you file your tax return, you will include the amount of the 401k plan that is cashed in as income, along with other sources of income. It flows into your tax return on the first page, and based on your total income and deductions you will either owe additional tax or get a refund.
Check on 401k Retirement Age Rules Before You Cash Out
If you are between age 55 and 59 ½ you may be able to avoid the 10% penalty tax if you terminated employment no earlier than the year you turned 55.
If you are over age 59 ½ any amounts you withdraw from your 401k plan will be subject to income taxes, but not penalty taxes.See 401k Retirement Age –Different Rules for Different Ages for additional details.
How to Cash Out of a 401k Plan
The first step to cash out of a 401k plan is to call the phone number that appears on your 401k plan statement and ask them to send you the paperwork to cash out of your plan. In some cases you may be able to do this online or over the phone, but most of the time you must fill out paperwork.
Sometimes a signature from a HR person or plan administrator at the firm that sponsored your 401k plan will be required. If you worked for a smaller company you may have to take this paperwork to them, or contact them yourself to get this done. If you worked for a large company this is often handled by the investment company that manages the 401k plan.
How Long Does it Take to Get Money Out of Your 401k Plan?
It typically takes several weeks to cash out your 401k plan. Some plans for smaller companies have the right to allow distributions only once a quarter, or once a year. The 401k plan document will spell out the rules for each plan.
Sometimes it can feel like your former employer is making it difficult for you to get your money out of your 401k plan but there are strict rules your employer must follow, and they must have all the proper paperwork to distribute your money.