A 401k plan can help you build savings for retirement, particularly if your employer provides matching contributions. However, if you quit, lose your job or get fired, you may wonder if you can cash out your 401k balance to meet your monthly expenses until you find another job. Federal law provides the option of cashing out your 401k balance if you become unemployed; however, this option comes with serious financial consequences.
Cashing Out Your 401k
After you become unemployed, your 401k plan administrator will provide you with notification of your account balance. Depending on plan rules and the amount of your 401k balance, the administrator may give you the chance to determine what happens to the money. If there is less than $5,000 in your account, the plan administrator can opt to send you a check without your permission. The administrator may also allow you to roll the funds over to an individual retirement agreement -- if you are not employed, you will not have the option of rolling the balance over to a new 401k plan. If the balance is more than $5,000, the administrator must also give you the option of leaving the money in the 401k account.
If your former employer made contributions to your 401k account, it may have imposed a vesting schedule. Vesting refers to ownership of the employer's contributions -- amounts not vested do not belong to you, and will not be included in the distribution if you cash out your 401k while unemployed. The vesting schedule varies by employer -- for example, your employer may stipulate that 25 percent of its contributions are vested after one year of employment; 50 percent after two years; 75 percent after three years and 100 percent after four years.
Taxes and Penalties
Cashing out your 401k balance before retirement will cause you to incur taxes and penalties on your distribution. The Internal Revenue Service will impose a 10-percent penalty for early withdrawal, which is deducted from the distribution. Your 401k plan administrator will also typically deduct 20 percent of the balances for taxes. This means that if you cash out your 401k balance while unemployed, you will likely lose 30 percent of your money.
If you cash out your 401k, you will lose the potential to save for retirement through your 401k plan. Even if you reinvest the distribution in an IRA or another employer's 401k plan later, the early withdrawal penalty and taxes will reduce the amount you have available for retirement investing. If you spend the money on monthly expenses, you will have to start your retirement savings over when you gain employment with another company that offers a 401k plan.