If you run into financial difficulty, you might think about cashing out a 401k before you are 59 1/2 years old, the retirement age. With several exceptions, cashing in your 401k early leads to a penalty tax as well as income tax on the amount you take out. If you decide to lend yourself money from a 401k, you will have to pay back that amount with after-tax money.
If you withdraw money from a 401k or cash in on the entire fund before you are 59 1/2 years old, you probably will have to pay a 10 percent penalty tax on the amount you withdraw. The penalty is in addition to any income tax you will owe on the amount you withdraw. If you cash in a 401k to convert it to an IRA, you are not charged the penalty if you do not take possession of the money.
In addition to the penalty tax, you will owe income tax on the amount you withdraw from a 401k. You would owe income tax whether you withdrew before or after reaching retirement age, because in most cases contributions to a 401k are made with pretax money. Your tax bill might be significantly higher if you take a large sum of money out of your 401k in a single year rather than receiving distributions over many years.
Instead of cashing in or withdrawing from a 401k, you may choose a 401k loan. You would avoid the 10 percent penalty tax and additional income tax if you lent yourself money from your 401k. But you'd lose the pretax benefit of the money in a 401k, as you would have to repay the loan using your after-tax income. In addition to repaying the principal, you would have to pay interest, also from your after-tax income.
A few exceptions to the 10 percent penalty tax for early 401k withdrawals exist. If you become completely disabled, you may cash in your 401k before retirement age without the penalty. You would have to provide proof that you were completely disabled. You can also avoid the penalty if you leave your job after age 55 and begin to take withdrawals. Valid reasons for leaving your job after age 55 include quitting, being laid off or retiring. The money in your 401k is exempt from the penalty tax if you pass away before age 59 1/2 and your estate withdraws the money.
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