When American consumers take a whack in the wallet – like they did with the coronavirus pandemic in the spring of 2020 – asking for relief from their 401k account is a legitimate question.
The legitimate answer is: “NO, DON’T DO IT!”
Not even if the federal government dangles some tantalizing incentives like removing penalties (temporarily) for early withdrawals, which they did during the COVID-19 pandemic in 2020.
The reason temporarily was bold-faced was the option ended December 31, 2020. The 10% penalty for withdrawals before the age 59 ½ is back in play.
Before the CARES Act was passed, taking an early withdrawal was available only to people 59 ½ or older. It was not an advisable choice before COVID-19 and it’s not an advisable choice after.
If you can avoid it.
A 401k account is a vital part of your financial future and should never be toyed with. However, if something drastic like COVID-19 brings the U.S. economy to its knees – and your job/income sinks with it – your 401k account might seem like the only ticket to get back on your feet.
It’s not … for two very good reasons:
- The value of stocks and mutual funds typically plummet during a crisis. Your investment might already have lost a significant amount of its value during a market downturn, meaning you already have significantly less money to borrow from.
- Less money in the account means you definitely will lose out on the gains from compounding interest that make long-term investing so attractive.
So, at the very least, you should avoid withdrawing funds from a 401k.
If all you want to do is close your 401k account, that’s easy. Simply go to your human resources department and make a request to stop paycheck contributions. There is no penalty for doing so. When the paperwork is completed, you aren’t cashing out the account, you’re just not contributing to it through your weekly paycheck.
Hardship Distributions from 401k Plan
If you are younger than 59 ½, you’re going to have to demonstrate that you have an approved financial hardship to get money from your 401k account. And that’s only if your employer’s retirement plan allows it. They are not required to offer hardship distributions, so the first step is to ask the Human Resources department if this is even possible.
If it is, the employer can choose which of the following IRS approved categories it will allow to qualify for hardship distribution:
- Certain medical expenses
- Costs relating to purchase of a principal residence
- Tuition and related education expenses
- Payments necessary to prevent eviction from or foreclosure on a principal residence
- Funeral expenses
- Certain expenses for repairs to a principal residence
The only other way to get access to your funds is to leave your employer.
Disadvantages of Closing Your 401k
Whether you should cash out your 401k before turning 59 ½ is another story. The biggest disadvantage is the penalty the IRS applies on early withdrawals.
First, you must pay an immediate 10% penalty on the amount withdrawn. Later, you must include the amount withdrawn as income when you file taxes. Even further down the road, there is severe damage on the long-term earning potential of your 401k account.
So, let’s say at age 40, you have $50,000 in your 401k and decide you want to cash out $25,000 of it. For starters, the 10% early withdrawal penalty of $2,500 means you only get $22,500.
Later, the $25,000 (remember, full amount withdrawn) is added to your taxable income for that year. If you were single and making $75,000, you would be in the 22% tax bracket. Add $25,000 to that and now you’re being taxed on $100,000 income, which means you’re in the 24% tax bracket. That means you’re paying an extra $6,000 in taxes.
So, you’re net for early withdrawal is just $16,500. In other words, it cost you $8,500 to withdraw $25,000.
Beyond that, you reduced the earning potential of your 401k account by $25,000. Measured over 25 years, the cost to your bottom line would be around $100,000. That is an even bigger disadvantage.
Finally, it is worth noting that the contributions you make to your 401k retirement account are tax deductible. The deduction occurs when you receive your weekly paycheck and the money comes directly from your pay. Your employer doesn’t include those amounts as taxable income at the end of the year.
Cashing out Your 401k while Still Employed
The first thing to know about cashing out a 401k account while still employed is that you can’t do it, not if you are still employed at the company that sponsors the 401k.
You can take out a loan against it, but you can’t simply withdraw the money.
If you resign or get fired, you can withdraw the money in your account, but again, there are penalties for doing so that should cause you to reconsider. You will be subject to 10% early withdrawal penalty and the money will be taxed as regular income. Also, your employer must withhold 20% of the amount you cash out for tax purposes.
There are some exceptions to the rule that eliminate penalties, but they are very specific:
- You are over 55
- You are permanently disabled
- The money is needed for medical expenses that exceed 10% of your adjusted gross income
- You intend to cash out via a series of substantially equal payments over the rest of your life
- You are a qualified military reservist called to active duty
What Happens If I Stop Contributing to My 401k?
If you are considering stopping contributions to a 401k, you would be better served to merely suspend those contributions. A short-term suspension will slow the performance of your retirement fund, but it won’t keep it from growing. It also will lessen the temptation to simply withdraw all the funds and wipe out retirement savings in the process.
Your Retirement Money Is Safe from Creditors
Did you know that money saved in a retirement account is safe from creditors? If you are sued by debt collectors or declare bankruptcy, your 401k and IRAs cannot be liquidated by creditors to satisfy bills you owe. If you’re having problems managing your debt, it’s better to seek alternatives other than an early withdrawal, which will also come with a high penalty.
Borrowing Money from My 401k
It may seem like an easy way to get out of debt to borrow from your retirement accounts for DIY debt consolidation, but you can only borrow $50,000 or half the vested balance in your account, if it’s less than $50,000. You won’t face a tax penalty for doing so, like you would with an out-right withdrawal, but you’ll still have to pay the money back.
And unlike a home equity loan where payments can be drawn out over a 10-to-30-year period, most 401k loans need to be paid back on a shorter time table – like five years. This can take a huge chunk out of your paycheck, causing you even further financial distress. Borrowing money from your 401k also limits the ability of your invested dollars to grow.
Paying off some of your debt with a 401k loan could help improve your debt-to-income ratio, (DTI) a calculation lenders make to determine how much debt you can handle. If you’re almost able to qualify for a consolidation or home equity loan, but your DTI ratio is too high, a small loan from your retirement account, amortized over 5 years at a low interest rate may make the difference.
Rolling 401k into IRA
When you leave an employer, you have several options for what to do with your 401k, including rolling it over into an IRA account.
It’s possible to do the same thing while still working for an employer, but only if the rules governing your workplace 401k allow for it.
The negative for rolling the money into an IRA is that you can’t borrow from a traditional IRA account.
Another option when you leave an employer is to simply leave the 401k account where it is until you are ready to retire. You also could transfer your old 401k into your new employer’s retirement account.
If you are at least 59 ½ years old, you could take a lump-sum distribution without penalty, but there would be income tax consequences.
Withdrawing from a Roth 401k
Most 401k plans involve “pre-tax” contributions, but some allow for Roth contributions, meaning those made after taxes already have been paid.
The benefit of making a Roth contribution to your 401k plan is that you already have paid the taxes and, when you withdraw the money, there is no tax on the amount gained as long as you meet these two provisions:
- You withdraw the money at least five years after your first contribution to the Roth account
- You are older than 59 ½ or you became disabled or the money goes to someone who is the beneficiary after your death
Debt Relief Without Closing My 401K
Before borrowing money from your retirement account, consider other options like nonprofit credit counseling or a home equity loan. You may be able to access a nonprofit debt management plan where your payments are consolidated, without having to take out a new loan. A credit counselor can review your income and expenses and see if you qualify for debt consolidation without taking out a new loan.
N.A. (2020, June 3) COVID-19 Related Early Withdrawals from Retirement Accounts – Be Careful of Fraudsters and other Bad Actors Targeting Your Retirement Savings. Retrieved from https://www.sec.gov/oiea/investor-alerts-and-bulletins/covid-19-related-early-withdrawals-retirement-accounts-be
N.A. (2019, June 18) Retirement Plans FAQs regarding Hardship Distributions. Retrieved from https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions#1
N.A. (2019, June 18) Roth Account in Your Retirement Plan. Retrieved from https://www.irs.gov/retirement-plans/roth-acct-in-your-retirement-plan
N.A. (ND) How to Cash Out a 401(k) When Terminated. Retrieved from https://www.fool.com/knowledge-center/how-to-cash-out-a-401k-when-terminated.aspx