Is Cashing Out a 401(k) a Bad Idea?

For some people, a 401(k) represents a significant amount of wealth. Building up a 401(k) over time could provide you with a chunk of capital to use later on in life.

But what happens if you’re in a tough spot and need some money immediately? Should you consider cashing out a 401(k) to access your money? In general, it’s a better idea to keep your money in a tax-advantaged investment account such as a 401(k) rather than withdraw it early. However, there are times that you might feel like there’s not much of a choice.

Here’s what you need to know before you move forward with cashing out a 401(k).

When can you cash out a 401(k)?

A 401(k) is a tax-advantaged investment account designed to help you save money for retirement. In return for providing a tax benefit, the government expects you to hold off on accessing the money in your 401(k) until you are 59 1/2. For many people, a 401(k) retirement plan is the first exposure to learning how to invest money.

You typically can’t cash out or withdraw funds from a 401(k) that’s sponsored by your current employer until you reach age 59 1/2. If you’re 59 1/2 or older, you could cash out a 401(k) from a current employer. If you’re younger than age 59 1/2, you could cash out a 401(k) after leaving a job or if you’re disabled.

Some plans also allow hardship withdrawals. If your employer allows hardship withdrawals, the IRS requires that they be due to an “immediate and heavy financial need” and limited to what you need to satisfy that need.

The IRS considers certain situations to automatically be “immediate and heavy” financial needs:

• Medical care for you, your spouse, or dependents
• Costs related to purchasing a primary residence (except for mortgage payments)
• College expenses for you, your spouse, or dependents
• Expenses to prevent eviction or foreclosure
• Funeral expenses for you, your spouse, or dependents
• Expenses to repair damage to a principal residence

Your employer’s plan administrator may require a written explanation that covers why that need can’t be met by other sources such as insurance.

Is cashing out a 401(k) a bad idea?

When you cash out a traditional 401(k) before reaching age 59 1/2, you could potentially see a bigger tax bill. First of all, in most cases, cashing out a 401(k) early results in a penalty of 10%. Next, you have to pay taxes on the money you cash out. If your 401(k) had $50,000 and you cash it out, you’re paying a penalty of $5,000 (10% of $50,000), and that money is added to your taxable income, boosting your total tax bill.

If your taxable income is usually $35,000 as a single filer, you’d be in the 12% tax bracket. But with the $50,000 now added to your taxable income, you’re at $85,000 and in the 22% tax bracket. Rather than having a tax bill of about $3,994.38, by cashing out a 401(k), you could end up owing $14,316.66 in taxes.

Add in that 10% penalty of $5,000 and you’re looking at a total cost of $19,316.66, which is $15,322.28 more than you would have paid without cashing out your 401(k).

If you’re age 59 1/2 or older, you could cash out all or part of your 401(k). You would pay regular income taxes on that withdrawal, which could bump you into a higher tax bracket. Although you wouldn’t face the early withdrawal penalty, cashing out would likely still have tax consequences.

Keep in mind that these are rough calculations based on 2023 tax brackets that don’t include other deductions and credits you might have. Your actual numbers will differ based on your individual situation.

If you’re cashing out your 401(k), it might make more sense to do it in stages rather than all at once. It will still cost you money, but you might be able to manage the chunk that goes to taxes.

Opportunity costs

Finally, when deciding whether to cash out a 401(k), you need to consider the opportunity cost associated with that early distribution. Once that money is out of your account, it’s no longer earning compounding returns.

Let’s say you leave that $50,000 account balance in your 401(k) for another 20 years, and see an 8% annualized return. Even without adding another dollar to the account, it could potentially grow to $233,047.86 if you left it alone.

As you can see, cashing out a 401(k) could cost you both today and in the future. Although you might be in an emergency situation and need the money, it’s a good idea to carefully weigh all your options before cashing out your 401(k).

Exceptions to the early withdrawal penalty

Not every early withdrawal comes with the 10% penalty, however. If you have a traditional 401(k), though, you’ll still pay taxes on the amount you cash out even if you don’t end up paying an extra penalty. Here are some of the circumstances in which you can withdraw money from your 401(k) without seeing the penalty:

• Having a qualifying disability
• Withdrawing periodic amounts on a schedule based on life expectancy, known as substantially equal periodic payments
• Begin taking withdrawals after leaving a job during or after the calendar year in which you turn age 55
• Paying for certain medical bills up to the amount allowed on your taxes as a medical expense deduction
• Experiencing specific disasters that have been recognized for relief
• Having a qualified domestic relations order

Before moving forward with these exceptions, speak with a knowledgeable tax professional who can help you understand the IRS rules for using these exceptions. For example, the rule of 55 allows you to take money from your 401(k) early if you leave your job in the calendar year when you’re 55 or older. However, you can only withdraw from the 401(k) that’s associated with the employer at the time you leave your job.

There are also specific rules attached to the substantially equal periodic payments exception. You might need help calculating your withdrawals and timing them in a way that prevents you from being stuck with higher taxes and penalties.

Additionally, the CARES Act allowed for COVID-19-related 401(k) distributions without an early penalty. On top of that, even though taxes were still due on the amount withdrawn, it was possible to spread out the tax payments over three years, making payments in 2020, 2021, and 2022, to reduce the immediate tax impact of a pandemic-related withdrawal. Although you can’t currently make new withdrawals under the CARES Act, you might still be dealing with the tax consequences of a coronavirus-related withdrawal in 2020.

All of the exceptions come with specific instructions and criteria, so you need to be able to document the way you use the money in case you’re audited in the future.

Alternatives to cashing out a 401(k)

If you don’t want to cash out your 401(k), there are ways to access the money and reduce your exposure to penalties and other costs. Before you resort to cashing out your 401(k), consider one or more of the following alternatives.

401(k) loan

If your employer allows it, you could potentially take a loan from your 401(k). This could help you avoid penalties and taxes. Additionally, it’s essentially a loan from yourself. You repay the loan into your 401(k), putting that money back over the course of five years.

However, it’s important to note that there’s still an opportunity cost. You miss out on the compounding returns the money would have earned if it had remained in the account during those years. The impact is much smaller than having the money permanently removed, though.

Be aware of the risks associated with a 401(k) loan. If you leave the job, whether you’re laid off or quit, you must repay the outstanding balance within 60 days or it is converted to an early withdrawal — with the accompanying penalty and taxes. To find out whether your employer offers 401(k) loans, contact your plan administrator.

Roll over to an IRA

Another option is to roll over your traditional 401(k) into a traditional IRA. There won’t be an early withdrawal penalty or a tax penalty if you directly transfer the money. The main advantage to rolling the money over is to avoid the early withdrawal penalty associated with taking money out before age 59 1/2 for certain activities.

For example, you can’t take a penalty-free withdrawal from a 401(k) to help with higher education expenses or a first-time homebuyer purchase. However, you could take money from your IRA to cover these costs without paying a penalty. You still have to pay taxes on the amount taken, but you avoid the early withdrawal penalty. If you’re looking for education help or to make a down payment on a home, an IRA rollover could be more helpful than a 401(k) withdrawal.

Personal loan

In some cases, you might want to avoid taking money from your retirement account and instead get a personal loan. If you qualify for a relatively low interest rate and could repay the loan quickly, it might cost less in the long run to get a personal loan than it would to withdraw the money from your 401(k). Double-check your credit score to see what you qualify for, and see if you can get a low rate and a payment schedule that helps you better manage your cash flow.

Review our list of the best personal loans if you’re considering this option.

Home equity line of credit

If you have equity in your home, a home equity line of credit (HELOC) could cost less and allow you to keep money in your 401(k). This could be one way to get access to a large amount of capital at a low cost. Find out how much you qualify for and check with multiple lenders to get the best rate. Remember, if you can’t afford your HELOC payments, you could potentially lose your home to foreclosure. Make sure you understand what you’re risking before you move forward.

Balance transfer credit card

Rather than cashing out a 401(k) to consolidate debt, you could see whether you qualify for a 0% APR balance transfer credit card offer. With this approach, you pay off your smaller debts with a credit card balance transfer. Then, during the promotional period with a low interest rate, you pay down the debt.

This could help you avoid using your retirement funds for debt consolidation and save you money on interest. Just make sure you have a plan to stay out of debt after using the balance transfer.

Check out our list of the best balance transfer cards if you’re contemplating this option.

Taxable investment account

If you have a taxable investment account, consider selling investments and using that money before cashing out a 401(k) loan. Firstl, if you sell investments you’ve held for more than a year, you could take advantage of a favorable capital gains rate. For example, someone with $35,000 per year in taxable income would be eligible for a 0% long-term capital gains rate.

There’s still an opportunity cost involved with taking money from a taxable investment account, but you avoid the early withdrawal penalty and might qualify for a favorable tax rate.

FAQs

Bottom line

Your 401(k) retirement savings represents a large chunk of funds available to you. However, it’s tax-advantaged money usually meant for saving for retirement. In many cases, cashing out a 401(k) could be costly, including penalties and taxes. There are ways to mitigate those costs, but there’s no replacing the opportunity cost when your money isn’t growing. Carefully consider alternatives to using your 401(k) and try to use it only as a last resort.