Most people in the USA make retirement savings through a 401(k) plan. This retirement account is made for your future, and there are a lot of rules set by the IRS, so you can’t withdraw funds on a whim.
What are your options if something happens and you have to access the money in this account? There are a couple of ways to do so, but is that the best idea?
We’re here to teach you more about cashing out your 401(k) and introduce you to the advantages and disadvantages of doing so. You’ll learn:
- Can I withdraw from my 401(k) while still employed without penalties?
- Can I cash out my 401(k) while still employed?
- What are 401(k) loans?
- What are 401(k) in-service withdrawals?
- What are the tax implications of cashing out your 401(k)?
- What are the disadvantages of cashing out your 401(k)?
- What are the alternatives to cashing out your 401(k)?
In this article, you’ll learn more about 401(k), saving money for retirement, and how to make the best decision for you and your family.
Can you withdraw from a 401(k) while still employed without penalties?
More than 62 million US workers are covered by these plans, and they collectively hold over $2.8 trillion in assets.
First, let’s look at the overall cashing out options.
There are a couple of ways you can withdraw money from your 401(k) without penalties. However, keep two things in mind.
First, this is a tax-deferred account, which means that you’ll have to pay taxes on the retirement funds you cash out. Next, if you withdraw money without following the rules, you’ll have tax penalties.
They usually all follow the same rules set by the IRS, but keep in mind that some of these instances can depend on your 401(k) plan administrator.
Can you withdraw from a 401(k) at 59 ½ while still working? The answer is yes. In fact, this is a normal penalty-free withdrawal.
Get a lump sum distribution, in annual or monthly payments, but remember that you’ll need to pay taxes.
Age 55 Exception
Depending on your 401(k) plan, you could withdraw the funds without penalties when you turn 55, or during the calendar year that happens, but only if you aren’t employed anymore. You’ll still have to pay taxes, though.
Age 50 Exception
If you work in public safety, you can withdraw funds penalty-free at the age of 50. People who worked for the police, firefighters, emergency medical services, or governmental units are eligible for this.
Required Minimum Distributions
According to the law, if you’re over 72 years old, you are obliged to make required minimum distributions from your 401(k) employer’s plan if you want to eliminate penalties. This rule also goes for people who inherit the account.
In the event of your death or the death of the 401(k) plan holder, the IRS allows the listed beneficiaries to withdraw the money from the account without the early withdrawal penalty. Just make sure that your list of beneficiaries is up-to-date.
Most plans state that only totally and permanently disabled people who are stopped from doing their job can apply to withdraw money from their 401(k) as disabled people.
However, this can differ from plan to plan. Either way, you’ll have to give your 401(k) custodian a letter, and they’ll need to verify your status.
Series of Substantially Equal Periodic Payments
If your plan allows it, you can agree to receive the same monthly payment without penalties from your plan for the next five years or until you reach the age of 59 ½. Another name for this is 72(t).
There are three methods for this:
- Required Minimum Distribution Method: This method uses the IRS RMD table to divide your account balance into equal payments based on your life expectancy factor and the number of years you’re expected to live.
- Fixed Amortization Method: Your payment is calculated based on one of three life expectancy tables made by the IRS.
- Fixed Annutization Method: your Equal Payments are determined using the annuitization factor made by the IRS.
High Unreimbursed Medical Expenses
In the case of medical expenses that are higher than 7.5% of your AGI (Adjusted Gross Income), you are allowed to cash out enough funds from your 401(k) plan to cover them.
Use this for yourself, your spouse, or dependents, but take the money out in the same year the bills are made to avoid penalties.
If you live in an area of the USA where natural disasters like floods and storms are common, your location is probably deemed eligible for disaster relief, and you can likely access your 401(k) funds without penalties.
Corrective Distributions of Excess Contributions
If excess contributions are made, you could return them without penalties under certain conditions and if your 401(k) plan allows it.
If the IRS takes money out of your account for tax purposes, this is usually penalty-free.
If you automatically get enrolled in a 401(k) plan you don’t want at your new job, you might be allowed to make withdrawals to switch to a different plan penalty-free. If your plan allows this, check if there’s a permitted time frame.
If you were called to active duty after September 11, 2001, and you served for at least 6 months, you may be able to take money out of your 401(k) without paying fees.
If the court orders that you give your 401(k) funds to your former spouse or a dependent in the event of divorce, you can withdraw the funds penalty-free.
Roth IRA or Roth 401(k) Conversion
You can roll over your funds from the 401(k) account and convert them to a Roth IRA or Roth 401(k) without penalties. However, to convert to a Roth IRA, you are usually required to leave your job, which is not the case for a Roth 401(k).
Birth or Adoption
This new penalty exception allows a withdrawal of up to $5,000 from your account within one year of the birth or adoption, and you can pay it back.
How can I cash out my 401k without quitting my job?
But what can you do if your situation doesn’t fit any of those mentioned above?
If you’re wondering “how to close out my 401(k) without quitting my job,” there are a couple of ways to get by. Although, they’re not the best choices.
Making an early withdrawal
As previously stated, in order to withdraw funds from your plan without penalty, you must be at least 59 ½ years old. This doesn’t mean you won’t be able to take money at all, but you’ll have to pay for taxes and early withdrawal penalties.
Making a hardship withdrawal
If you declare hardship, need money for certain expenses, and your situation fits the rules, you can withdraw some or even all the funds without an early withdrawal penalty.
Taking out a 401(k) loan
If you need to access the assets in your retirement plan but aren’t entitled to any other variety of withdrawals, you could take out a loan against your 401(k) if your plan provider allows this.
You’re borrowing the assets from your future self, and you will have to pay them back to the same account with interest.
Even though it can be tempting, there are many disadvantages to taking out a loan against your 401(k), and we will delve into all of them next.
You have to be currently employed to take out a loan against your 401(k), but not every plan provider allows this. You’ll have to confirm this with the HR department. Although in 2018, 78% of 401(k) plans permitted plan participants to take out a loan against their plan.
So if you’re wondering, “Will my employer know if I take out a 401(k) loan?” the answer is yes, they will.
Next, you should only borrow against your 401(k) if you have no other early withdrawal options, but it’s still not the best option.
The loan limit is up to 50% of your vested funds, or up to $50,000, without penalties, and you’ll have to pay it back with interest. The good news is that you can use this money for anything you want, and you can set up automatic repayments.
The exact interest rates depend on your plan, but you have to pay it back in up to five years. This means that at least you’ll end up with more money than you started with. If you don’t cover the debt in that time frame, you’ll have to handle some extra taxes.
However, there’s a big problem with 401(k) loans. If you lose your job in those five years, you’ll have to reimburse the loan. Otherwise, they’ll be treated as income, and you’ll get taxed on top of an additional 10% early withdrawal penalty.
Your retirement account may have repayment rules that continue after you leave the company, so you won’t have to pay income tax or a penalty. This is something else you should ask your plan provider about.
There are more disadvantages to taking out a loan against your 401(k) than there are advantages, so in case you have to do it and you have no other alternative, make sure to be ready and to work on having emergency funds in case you have to reimburse the loan immediately. Also, it might be best to consult your financial advisor before choosing to take out this loan.
In-service 401(k) withdrawals
Most 401(k) retirement accounts offer in-service withdrawals, but the rules can vary.
Users who are eligible for an in-service withdrawal without penalties are typically employed people over the age of 59 ½ and those who are eligible for a hardship withdrawal.
Some employers will let you make in-service withdrawals if you want to roll over your funds to a separate account or a similar plan. Younger plan participants can only roll over their own contributions and earnings, without employer contributions. Older plan participants can roll over all of their vested assets.
If you withdraw retirement money instead of taking out a loan, it will be seen as taxable income, and if you are under the age of 59 ½ in most cases, you will have to pay a 10% penalty for early withdrawal.
The good news is that in this case, you don’t have to reimburse the funds like you do when you take out a loan against your 401(k).
Hardship withdrawals, as mentioned before, are a type of early withdrawal made because of immediate and heavy financial hardship. The rules can vary depending on your retirement plan administrator, but some things are similar.
If the employer’s plan permits it, you can get access to some or all of your money in the 401(k) account for a hardship distribution. Most plans don’t include employer matching contributions in the amount that you can withdraw.
The IRS defines the criteria for hardship distributions as follows:
- You have immediate and heavy financial need.
- This withdrawal is necessary because you don’t have any other source of available funds that will help you meet your needs.
- The amount of money that you take can’t exceed the amount of money that you need for an emergency.
Here are some of the IRS approved categories of financial difficulties when you can ask for a hardship withdrawal:
- High medical bills for you, your spouse, or your dependent that need to be paid immediately;
- In case you need to keep your principal residence from foreclosure or eviction.
- To pay for burial and funeral expenses;
- To pay for college tuition or post-secondary education expenses for the next 12 months;
- You need a down payment for buying your primary residence (up to $10,000, excluding mortgage payments);
- You need money for immediate repairs on your principal residence.
This is handled as taxable income, and you might even have to pay the 10% penalty fee. However, you’re allowed to take out enough money to pay income taxes, and you don’t have to pay it back to the borrower’s account.
However, keep in mind that you can’t put money back into your 401(k) plan for six months after taking out a hardship withdrawal.
Tax implications of cashing out 401(k)
The assets that you put in your 401(k) are tax-deferred, which means that tax consequences come later, except in rare cases. Here’s some advice that we can share with you.
Leave the money alone
We discussed 401(k)s and how the phenomenon is that you never know what taxes will be like in the future or whether it’s best to cash out your 401(k) now or later.
However, compound interest only works if you leave the funds alone. Taking out some money now can cost you more in the future, so you should let it grow.
Every time you withdraw money, you have to pay taxes, and most early withdrawals come with penalty fees.
Move the money to a new 401(k) plan.
Moving the funds to a new 401(k) from the former employer isn’t taxed, and there aren’t any penalties except in one case.
If you don’t opt for a direct rollover and choose an indirect one instead, you have to get your assets onto a new employer’s plan in 60 days, or you’ll have to compensate for taxes and the 10% penalty.
Establish a rollover IRA
If you change jobs and have more than $5,000 in your account, your plan sponsor will usually distribute the funds to you, but there will be a 20% penalty if you are under the age of 59 ½ .
You can roll over your funds into an IRA account to avoid this, but you have to do it within 60 days. You can also put your assets into a traditional IRA to avoid current taxes.
There’s a difference between a direct and indirect rollover, though. A direct rollover implies that the assets move directly from your previous 401(k) plan to the one at your new job and plan sponsor. The indirect rollover occurs when you receive the funds as a distribution from your previous employer but have to put them into the new account within 60 days or face taxes and penalties.
Cash out and take a distribution
Early distributions are always penalized. If you are under the age of 59 ½ and want to withdraw funds from your retirement account, you will be charged a 10% excise tax on the amount you withdraw. The exemptions for this penalty are in cases of disability, medical bills that exceed 7.5% of your gross income, or if you retire after the age of 55.
When you put money into a 401(k), your taxes were put off. This means that any money you take out is taxed according to your tax bracket.
When it comes to loans, there are no taxes as long as you reimburse them on time. If you don’t, you will get taxed at regular income rates, and you will have to pay the 10% penalty fee.
We didn’t take any relevant state income tax into account, but you should also always keep that in mind.
Should you cash out your 401(k)?
The short answer is — no.
Cashing out your 401(k) is something that you shouldn’t do if you can help it because it’s usually a bad idea in the long run.
Early withdrawals make you lose money through income taxes and penalty fees. But if you leave the money alone, it will grow over time due to interest rates.
Retirement savings should be taken seriously. Don’t rob your future self!
The good news is that the safety of your 401(k) retirement account is legally guaranteed, even if you file for bankruptcy.
Alternatives to cashing out 401k
Cashing out your 401(k) comes with a lot of disadvantages. Saving for retirement is serious business, but if there were a better way to build your wealth with more accessible funds?
Say hello to infinite banking.
With infinite banking, you don’t have to deal with income taxes, early withdrawal penalties, or any other rules set by the IRS. You’re completely in charge of your own money!
How do I start infinite banking?
The first step in infinite banking is to buy a whole life insurance policy from an insurance company.
When you build a high cash value on your policy, you can let that money grow at the guaranteed interest rate or borrow money against the policy.
This isn’t like a 401(k) loan, because you set the rules. You’re the one approving it, choosing how much money you want to borrow, what the interest rate will be, and when you’ll pay it back.
You’re basically creating your own bank, but without all the fees and rules you usually have to follow. The way you build your bank depends on what you need in life, which is also why we call it “lifestyle banking.”
Want to find out more?
We hope that we helped you understand your 401(k) plan better and that you realized that cashing out your retirement funds isn’t always the best choice. It’s better to look for alternatives and build your wealth.
We are looking forward to seeing you in the Wealth Nation community!