What Happens if I Cash Out My 401K?
Planning for your retirement is essential. Most people receive a retirement benefit and advice when they join a large company, but even the most stable working conditions can change. Unexpected costs can tempt you to put your retirement savings on hold in favor of access to quick cash.
Whether you’re approaching retirement or simply changing jobs, you have probably considered cashing out your 401(k). Maybe you have, only to be met with a drastically reduced sum that’s been slashed in half (if you’re in the top tax bracket) by tax and withdrawal penalties.
As tempting as it is, cashing out is a massive mistake that as many as 30% of people make before they reach the age of 60.
If you’re thinking about withdrawing the money instead of holding out, then this is the article for you, as we discuss the pros and cons of cashing out your 401(k).
Table of Contents
Thinking Ahead: The Long-Term Consequences of a 401k Cash Out
Moving jobs is a tricky time financially. You might have to move cities or adjust your fuel budget to cover a longer commute. There is also a heap of paperwork associated with transferring any retirement funds from one company to another.
It is tempting to cash out your 401(k) when you need capital – it’s even more tempting if you’ve been cut back or are battling against debt. While it might seem like an easy way to access the funds you need, this seemingly small amount is set to get you through the years when you don’t earn a fixed income, and putting this security in jeopardy can be catastrophic.
The issue is replacing your hard-earned savings. Unlike normal rainy day funds, this is an account designed to cover your retirement. Can you really afford to sacrifice years of savings for a quick fix? The reality is that debt and unexpected costs can make it difficult to save, so raiding the retirement fund is a consideration that shouldn’t be taken lightly.
The reason these savings should be protected at all costs is that they are structured to deliver gradual growth over a significant investment period. They give you the security of compound growth that’s not touched by tax and make it possible to save a substantial amount.
It’s even possible for the earnings from the interest in these accounts to start earning outright, which makes them vastly superior for long-term planning.
The urge to cash out puts this wealth at risk. In fact, studies suggest that the average payout is only $15,000. Given the time and structure to grow, that amount could comfortably cover the expenses associated with a content retired life.
While it might be acceptable to cash out later in life, it is near-sighted to halt the projected growth of your wealth 25 years too soon. When you consider that an IRA can turn $5,500 into nearly $60,000 by the time you retire, it’s easy to see why experts agree that your 401(k) should stay intact for the duration of your career.
Applying for Relief
Life and finances often take unexpected turns that can turn a comfortable situation into a serious financial hole.
Whether you are moving to a new company and aiming to cover costs or are desperate for cash, the results of raiding your 401(k) are equally negative.
It is advised to take out a loan rather than dip into your savings. If that is not possible, you might be able to apply for a hardship withdrawal.
This is a specific type of transaction that allows you to take a percentage of your 401(k) savings out for personal use. It can be a lifesaver, but again, this is not a decision to be taken lightly. Apart from the fact that you will probably have to pay a 10% penalty, you will also need to pay back the full amount with interest.
This is challenging enough, but the consequences reach further than repayment. For example, the funds you withdraw could grow exponentially if the market spikes, and you will miss that opportunity.
Then there’s the question of repayment if you’re cut back. Your boss might expect you to pay the outstanding amount on your hardship withdrawal, which means you’re faced with a huge, urgent payment yet again.
The first is the 20% penalty you will pay to the IRS, which is taken directly to cover the tax you would pay on the withdrawal. This means that years of saving are wasted in a massive payment to the IRS, which means you get less money out and put your retirement in jeopardy.
Apart from this tax cover, you will be expected to pay both federal and state income taxes, as well as a 10% early withdrawal fee (provided you’re under the age of 59).
Put another way, cashing out your $50,000 401(k) will only put $35,000 in your hand.
Despite this drastic loss, more young people are choosing to cash out early. While they risk an uphill battle to secure their financial future, it often feels like there is no other option available. However, there are a range of options available to people looking to access savings reserved for retirement.
There are a few options when it comes to protecting your 401(k). Most are simple to understand and can help you sustain and grow your savings eventually. Although there are different options available, the majority focus on transferring 401(k) savings into IRA structures in a transaction known as a rollover.
Traditional 401k and IRA accounts protect your contributions from tax until you make a withdrawal. You can add to the account tax-free, and only start paying tax when you take money from the fund.
Although every fund has different rules and processes, it’s normally easy to initiate a rollover. This generates a check that is payable directly to your IRA provider, which means you won’t have to pay any tax or penalties.
There is also the option of an indirect rollover, where the payout check is paid directly to you. While this gives you more control, it also burdens you with the responsibility of transferring your savings into a tax-advantaged account.
Indirect rollovers are also subject to a mandatory 20% deduction, meaning you need at least 20% of your total savings to put the full 401(k) amount into an IRA.
Failure to make a full payment could mean that the IRS sees the difference between your retirement plan balance and your rollover contribution as a withdrawal, even though they already have the money withheld. This could lead to further tax penalties.
It’s a tricky process, and one wrong move could see you facing massive penalties. A prime example is the fact that you only have 60 days to move your money into an appropriate account.
The tax-man takes a long, hard look at indirect rollovers, and you will be expected to answer for every detail. Therefore, save yourself the hassle and reduce the risks with a direct rollover – it’s far less risky, and you don’t have to worry about costly oversights.
The Roth IRA
Roth IRA funds offer you tax-free growth and a range of withdrawal options, but once again, if you move your money out of a 401(k) into this type of account, you could face a mammoth tax bill.
Straight of the bat, pretax contributions made to your 401(k) are now subject to tax because they do not enjoy the safety and tax exemption offered by this account structure.
If you move $100,000 from your 401(k) into a Roth IRA, you instantly lose 25% (if you’re in that tax bracket). That’s $25,000 you owe the taxman. You can pay this out of your pocket to protect your retirement savings, but chances are if you’re considering a transaction of this nature, you do not have that kind of money lying around.
You may ask why people would consider this type of rollover at all. People who expect to face higher taxes once they retire may find it beneficial, but this is rare, particularly if you have a range of accounts growing your wealth as you age.
It’s always best to consult a financial adviser or tax expert to discuss the advantages and disadvantages of a Roth rollover.
Understanding Your 401k Rights
It’s clear that your 401(k) is better left untouched, even when moving to a new company.
Talk to your employer about whether your retirement fund is linked to your employment or not. In many cases, you can leave your savings earned in an active 401(k) even when you move on.
You won’t be able to make the monthly contributions that were deducted from your salary, but the amount accumulated in the account is still protected from tax and will grow.
You might also be able to transfer your existing 401(k) savings into your new employer’s retirement system. This is a simple process that ensures regular contributions, but make sure that you have a good understanding of the new company’s costs, fees, and investment options before you assume that this is the most profitable choice.
There are 3 core comparisons that you need to make when deciding whether to move your 401(k) savings into an IRA or not.
IRA providers charge differently, so compare the overall costs for your planned investment term and not just the annual fees.
Remember, there are management fees, admin fees, broker fees, investment fees, and a variety of hidden costs to consider.
Once you have analyzed the fees associated with each account, you need to consider the spectrum of investment options available. 401(k) plans do not offer much scope for choosing funds based on your risk appetite. IRAs do give you that choice, empowering investors with access to mutual funds as well as securities.
You need to choose the options that gives you what you need in a manageable, affordable way. If you don’t have the expertise to leverage the range of options available from an IRA, it’s best to play it safe.
Lastly, there’s the question of liquidity and investment security. Do you think that you will need access to liquid funds? If so, the flexibility of an IRA might be called for. A 401(k) protects your savings and may offer access to a percentage withdrawal, but again, this has serious consequences as discussed.
Diligence is Important
You need to be responsible and diligent when it comes to maintaining a 401(k). Apart from the fact that you will only reap maximum rewards at the end of a career characterized by patience, you need to keep thorough records.
It is surprisingly easy to forget about a fund after 40 years, and you cannot always rely on a financial services company to keep track for you. Take charge and make sure you’re aware of what’s in the bank. It’s also recommended to assign someone as a backup to your own financial management.
Whether you decide to move your funds or not, the key to securing a stable retirement, from a financial point of view at least, is to protect your savings as much as possible and keep funds in a tax-advantaged account.
Not only will you benefit from compound interest and gradual growth, but you will also avoid the extreme losses brought on by penalties and withdrawal tax.
Ultimately the choice is up to you but choose wisely to avoid a lifetime of financial struggles.
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