Tax Law for Cashing Out a 401(k) to Pay Debt

by Cindy Quarters, studioD

A 401k is a type of employer-sponsored retirement plan that you contribute to while you are working, then is use as a source of funds once you retire. Since the intent of a 401k is to provide funds after retirement, tax laws favor those who wait and penalize those who take funds out of their accounts too early. There are ways, however, to access the funds without paying the penalties, but it depends on the situation.

Close the Account

A 401k cannot be closed while you are still employed with the company where you have established the savings plan. The only way to completely cash out is to stop working for the company that sponsored it. This means either changing jobs or retiring. Unless you are retirement age, closing your account means you will have to pay both income tax plus a 10-percent penalty on any money you get.

Hardship Distribution

You may be able to take some of your funds if you qualify for a hardship distribution and your plan allows it. The IRS specifies certain requirements for such withdrawals. If you qualify you may be able to get some or all of your contributions, but not any earnings or matching funds. You will have to pay income tax on the money, but if it is to prevent eviction, to buy your first home, to pay large medical bills or one of several other situations allowed by the IRS, there is no penalty added.

Partial Rollover

If you have money in a 401k with a previous employer, you can all take all of the vested funds from the account, if you wish, then keep part of it for bills and put the rest into another qualified retirement account, such as an IRA or a new 401k. You will have to pay income tax on any portion that you use to pay your debt. Unless you are at least 59-1/2 or have become disabled, you will also have to pay the 10-percent penalty. If you do a rollover, taxes will be deferred on the amount that is rolled into a new plan until you draw the money out at retirement, and no penalties are due.


Many 401k plans will allow you to borrow from your account. You need to check the plan documents to see if this is an option for you. The general rule is that you can borrow up to half of your vested funds or a maximum of $50,000. It has to be paid back, with interest, within five years. Normally a loan from your 401k plan is not taxable as long as you repay on time, making essentially equal payments. Failure to pay it back can trigger taxes on any unpaid amount.

About the Author

A recipient of a business and technology degree from the master's program at West Coast University, Cindy Quarters has been writing professionally since 1984. Past experience as a veterinary technician and plenty of time gardening round out her interests. Quarters has had work featured in Radiance Magazine and the AKC Gazette.

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