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Cashing Out Your 401(k) is a Costly Idea

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By Laurie Itkin
 

When I was interviewing women for my book, Every Woman Should Know Her Options: Invest Your Way to Financial Empowerment, several ladies told me they had cashed out their 401(k) accounts when changing jobs. Instead of leaving the funds where they were or transferring the funds into a new employer’s 401(k) or an individual retirement account (IRA), they chose to spend the cash instead of letting the money grow.

 

Take Julie, who had about $10,000 in her 401(k) when she left her job at age 29. Had she kept the money in the 401(k) or rolled it into an IRA, by the time she turned 62 the account would have been worth $100,000 (assuming a 7% annual rate of return on her investments). That is a tenfold increase!

 

But she chose immediate cash instead. Since she wasn’t yet 59 and a half, the IRS assessed a 10% penalty. She also had to pay federal and state income tax. At the time she was in the 25% federal tax bracket and the 9.3% state tax bracket. So out of $10,000, she was left with $5,570 in cash and nothing saved for retirement.

What would make someone take $5,570 today instead of $100,000 in the future? According to Hewitt Associates, it happens quite often. A decade ago, Hewitt found that nearly half of workers cashed out their 401(k) when leaving a job. I certainly hope things have changed since then.

 

Of course, financial emergencies happen. Your car might need new breaks. You might have to fly cross-country for a funeral. You might need medical care and have to meet a high deductible before insurance kicks in. But that is why it is so important to have an emergency fund in a savings account–so you don’t have to raid your 401(k).

 

Taking Money Out of a 401(k) While Still Employed

Generally, you cannot take a withdrawal from your 401(k) until your employment ends, unless the 401(k) plan allows “hardship withdrawals.” Not all employers offer hardship withdrawals. Some things that might meet the definition of “hardship” include: medical expenses; a down payment for a home; tuition; payments necessary to prevent eviction from or foreclosure on your home; funeral expenses; and repair of damage to your home.

 

Despite the withdrawal being for one of these valid reasons, you will have to pay federal and state income taxes and as well as a 10% penalty if you are not at least 59 and a half. You may be able to avoid the 10% penalty tax if you are disabled, you have medical debt that exceeds a certain percentage of your income, or you are required by a court order to give the money to your ex-spouse or a dependent.

 
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For example, when divorcing couples are dividing a 401(k), a qualified domestic relations order (QDRO) can be drafted to split the account without penalty. If the funds granted to the non-employee spouse are rolled into an individual retirement account (IRA), no penalty or taxes will be assessed. But if the non-employee spouse takes the money in cash, he or she will have to pay income taxes (but no penalty) assuming the QDRO is drafted correctly.

 

There is another case in which you might not have to pay the 10% early withdrawal penalty if you are under 59 and a half. That’s if you’re at least 55 years old at the time you separate from the company sponsoring your 401(k). In that case, you’re allowed to take a lump sum distribution from your 401(k) without paying the 10% penalty, but you will still have to pay income taxes.

 

A 401(k) Can Be Considered Separate Property Not Subject to Division

If you owned a 401(k) before marriage, most states treat the account balance before marriage as your separate property. Although state laws vary, many states will also treat the appreciation of that 401(k) as separate property. However, if you continue to contribute to your 401(k) while married, typically the contributions and employer match (and appreciation of the contributions and match) would be treated as community property subject to division. The important takeaway, however, is that if you had money in a 401(k) prior to marriage and you can prove it by showing a historical account statement, then that is money you should be able to keep after divorce. And depending on the state, appreciation on that money might be yours to keep as well. So don’t just assume that your entire 401(k) will be split 50/50 upon divorce.

Taking Out a 401(k) Loan

If you don’t have an emergency fund and have no alternative other than tapping your 401(k) for emergencies prior to retirement, then you’re better off taking that money out as a loan than as an early withdrawal, provided your plan allows for loans. However, 401(k) loans carry risk. If you separate from your employer before paying back your loan, you’ll generally have only 90 days to repay it entirely before it’s treated as an early withdrawal and penalized as such. And if your separation is a result of being laid off or quitting before you have a new job, you might find it difficult to come up with the cash to pay off your loan.

 

Cashing out your 401(k) is a costly idea. Not only do you potentially pay hefty taxes and penalties, but you delay the age at which you can retire. The sooner you can build up a robust retirement account, the sooner you can stop working.

 

Laurie Itkin is a financial advisor, certified divorce financial analyst (CDFA), and the author of the Amazon bestseller, Every Woman Should Know Her Options. For less than the cost of a one-hour meeting with an attorney, her online course, Woman’s Guide to Financial Independence After Divorce, teaches separated and divorced women essential financial concepts. You can request a free consultation or subscribe to Laurie’s newsletter by visiting TheOptionsLady.com.
 

Laurie Itkin explains why early 401(k) withdrawals are a dangerous idea and what you need to know if you're planning to cash out your retirement account.
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