Have you ever wondered if you could access the money in a 401(k) plan to use for other purposes before you actually retire? It is possible, but there are limitations to accessing money in any tax-qualified plan.
You see, some of the money in these plans, is really the government’s money because you haven’t paid the taxes yet. Thus, the government wants to have a say in how you can get to the money.
Many financial advisors discourage a 401(k) early withdrawal because of:
Whenever you consider an early withdrawal from a 401(k) plan, you’ll want to know the cost associated, to make sure this is still a good option.
Be sure to consider your reasons carefully and clearly, rather than making a spur-of-the-moment decision. It’s worth thinking twice before losing money, even if you expect to save or make more money by taking a short-term loss.
And if you think you may need money you are contributing to a 401(k) today, sooner than retirement, it may be a good idea to keep that money in a place that will be more accessible rather than trying to get it out of the 401(k) later.
This depends on your employment status, age, and possibly some other factors including whether you qualify for a hardship withdrawal.
The phrase “cashing out” implies that you want to take everything out of the plan, but it may be that you only need part of the money (or can only get to a part of the money in a plan). Either way, taking cash out of a 401(k) is considered a withdrawal.
If you’re still employed with the company that sponsors your 401(k) plan, you may not be able to withdraw funds unless you qualify for a hardship withdrawal or quit your job.
Hardship withdrawals may be available for various reasons including:
The decision of whether you qualify for a hardship withdrawal is up to the administrator of the plan. You can submit special cases for consideration, and they may ask you to explain why you cannot get the money somewhere else. If the administrator determines you do not qualify for a hardship withdrawal, then your request may be denied.
Some 401(k) plans may allow for in-service withdrawals while you’re still employed, so you can check your plan documents to see if this is allowed.
If you are no longer employed, you can usually cash out a 401(k) plan. There may or may not be a penalty, depending on your age.
If you’re under age 59 ½ and can take a non-qualified withdrawal from your 401(k), you will most likely have to pay a 10% penalty as well as taxes on the amount withdrawn.
If you simply want different investment options than are available in your current plan, it may be possible to do a rollover to an IRA where your desired investments might be available. Rolling money from a 401(k) to an IRA can be a good way to avoid the 10% penalty when you’re under age 59 ½.
If you want to cash out, the withdrawal process is usually easy and involves:
How long does it take to cash out a 401(k) after leaving a job? A common time frame for receiving the funds is 3-10 business days. Smaller plans may only make account distributions once a quarter or once a year, so wait times could be longer.
Can you ever take money out of your 401(k) without penalty? Sometimes special conditions are available to avoid taxes and penalties such as the one-time withdrawal of up to $100,000 allowed by the CARES Act due to economic hardship/disaster in 2020.
It’s worth doing some research to see what options may be available when you’re trying to avoid taxes and penalties on a 401(k) withdrawal.
If you quit your job, or the job terminates, when you are 55 or older, you can qualify for penalty-free distributions from a 401(k) connected with that job.
It’s important to know this rule does NOT apply if you quit your job at age 54 and then try to take a distribution at age 56. It also does not apply to a 401(k) from a different job or a personal IRA. It only applies to the 401(k) plan from the job terminated at the age of 55 or older.
If you’re no longer employed, there may also be an option to set up a series of substantial equal periodic payments according to section 72(t) which would allow you to start withdrawals from a 401(k) over a period of 5 years or until age 59 ½, whichever is longer.
These periodic payments must be calculated according to one of three IRS-approved methods: fixed amortization, fixed annuitization, or required minimum distribution.
There are more conditions and moving parts to this type of arrangement, and you can’t change your mind later if you decide you don’t want to make a withdrawal in one of the appropriate years.
This option should be used with caution because if something goes wrong, then the withdrawals you did take become subject to the 10% penalty + interest.
It’s worth noting for all withdrawals, that the plan administrator is required to withhold 20% of your withdrawal from a 401(k) for taxes, even if you expect to get a tax refund in the year you make the withdrawal.
This means if you request a $10,000 withdrawal you can expect to receive a check for only $8,000.
Important Note: Unless you have a Roth 401(k) plan, all withdrawals/distributions from a 401(k) are taxable even if there is no penalty for the withdrawal.
If you need money today, a 401(k) may seem like an easy place to find it, but this could end up costing more than you think. When you compare the pros and cons, you may find it better to take out a personal line of credit, a life insurance policy loan, or utilize other assets, rather than pay a 10% penalty.
If you have a true emergency, and this is the only way to get money, then perhaps it is the best option for you. But a 401(k) is usually not the best place to look for emergency savings.
If a 401(k) is part of your plan for retirement and you take a withdrawal, realize that you will suffer a loss of compounding and time, and it is not possible to just put the money back into the 401(k) in a few years.
There are a number of situations where it might make sense to cash out a 401(k) including:
Several years ago, my parents were at a time of life where they wanted to make some investments in their growing family and start a new business. These investments were not allowed within their tax-qualified plans.
They chose to withdraw money from a SEP and personal IRA, using the funds to help me and my siblings develop talents and fund our new family business. This worked out in a great way, both financially and from an experience-building perspective.
Very few financial advisors would ever have recommended my parents to do this, but to this day they are glad they made that decision.
If you believe you can make up for a 10% penalty and create more value from using the money in ways not allowed in a tax-qualified plan, then cashing out a 401(k) might be a good thing for you.
Be sure you have a plan of what to do with the money and how to make up for the 10% penalty if you do choose this route. And remember that not all businesses or investments are successful.
If you’re over age 59 ½ and the 10% penalty doesn’t apply to you, then it might be a good time to cash out a 401(k) if you want a lower level of taxable income in retirement, with more tax-free assets/income.
Many people are surprised to learn that 50-85% of Social Security income may be taxable in retirement. It is also likely that you won’t have some tax deductions which you currently do, such as children/student dependents and interest on a home mortgage which may be paid off in retirement.
Considering taxable income sources in retirement, it may be attractive to take withdrawals from a 401(k) and pay the taxes sooner, to decrease future taxes. It’s always a good idea to look at your numbers and research the options before making this type of decision.
Death and taxes are two certainties in life. Generally speaking, taxes increase over time while deductions for most people decrease over time. Unless Congress takes a special action, we know some favorable tax reductions for most middle-class Americans will sunset in 2026.
If you think taxes will be higher in the future, or you know your deductions will be lower, cashing out a 401(k) to move money to a place that does not pay taxes again can make sense.
Among other things, potential tax-saving strategies may include a rollover to a Roth IRA or buying permanent whole life insurance designed for high cash value accumulation.
Note: If passed into law, pending legislation could substantially change Roth IRA regulations after Dec 31, 2021 – especially relating to distributions and rollovers.
When cashing out a 401(k), be prepared for the penalties and taxes. Penalties are usually easy to estimate when they apply, but potential taxes can be more elusive.
One assumed benefit implicit in any tax-deferred plan is that you will withdraw the money in a lower tax bracket than you deferred the tax when you made the contributions. This is not always the case, but taking an early withdrawal in a year when you have a high level of income ensures that you will never see this potential benefit on the amount withdrawn.
If you have existing income for the year, a big withdrawal might put you in a higher tax bracket or at least ensure you’re paying taxes on most of the withdrawal at your current tax rate without the benefit of the lower rates in our graduated tax system. Lower tax rates may apply to at least a part of the distribution if you were to take a similar withdrawal in a year where you do not have as much other income.
Also, if you have a true emergency and pull money from a 401(k) to cover that emergency, then what about the taxes and penalties which are due next April 15th? Could your initial withdrawal start a chain reaction that may force taking another withdrawal to cover taxes?
Make sure you have a way to pay the taxes on 401(k) withdrawals.
Many people like to fund whole life insurance during their career instead of maxing out 401(k) contributions. High cash values in life insurance can be valuable when opportunities arise where 401(k) funds are off-limit.
For example, my brothers run a metal fabrication business and recently had an opportunity to buy a machine shop for only $50,000 on a special liquidation deal. This equipment would have run close to $250,000 if they had to buy it piecemeal at used prices.
They were able to get a policy loan against their whole life insurance policies and take advantage of this deal quickly.
Some people like to fund whole life insurance with money from a 401(k), so they have a permanent death benefit and accessible cash values going into their golden years.
If they need more money during retirement 10-15+ years later, they can withdraw more than they paid for the policy(s) or roll a policy to an annuity to create guaranteed passive income for the rest of their life. A high percentage of this income is usually tax-free.
Owning life insurance can also help with estate planning needs or as a volatility buffer where a policy owner can take a loan or withdrawal to cover lifestyle expenses in times when volatile market investments are down. This can allow time for the market to recover instead of further drawing down assets in an invested account.
Not all life insurance is designed the same, and it is possible to have too much life insurance, so you’ll want to make sure you get a good policy(ies) for your needs.
There are consequences for cashing out a 401(k), so be sure to consider your options wisely beforehand. Most financial advisors will tell you not to cash out a 401(k) early, but there are cases where it can make sense to do this.
Life insurance can be a good financial tool to:
At McFie Insurancewe specialize in designing participating whole life insurance to meet client needs. To see how a good policy might work in your situation call us at 702-660-7000 or schedule a strategy session with our team.
Note: Investing and retirement information provided on this page is for educational purposes only. McFie Insurance does not offer advisory or brokerage services and does not recommend or advise investors to buy or sell particular securities.
by John T. McFie
I am a licensed life insurance agent, co-host of the Wealth Talks podcast and co-author of Retirement Curveball.
At age 14 I started developing spreadsheet models and software systems to help my Dad share financial concepts with clients.
Skipped college at 17 recognizing the overinflated value and prices of most college degrees and built more financial software instead (see MoneyTools.net). Still a strong advocate of higher education without going to college. I enjoy making financial strategies clear and working through the numbers to prove results you can count upon.
by John T. McFie