Why Cashing Out Your 401(k) Is Not a Good Idea

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When you want money to buy a large item such as a car or a house, withdrawing it from your old 401(k) might sound like a good idea. After all, the money is yours if you are fully vested, and you can do with it what you want. The more you think about it, cashing out your 401(k) may seem like a good idea—but it really is not.

The Penalty

If you are not yet 59½, you must pay a 10 percent 401(k) early withdrawal penalty on whatever amount you withdraw. It could be a rather hefty sum. In addition to the early withdrawal penalty, you must pay income taxes on a 401(k) withdrawal.

Income taxes vary according to your income. In 2024, the brackets start at 10 percent, then go up to 12 percent, 22 percent, 24 percent, etc. If you have $15,000 in your 401(k) and are in the 24 percent tax bracket, when you cash it out, you will have to pay $3,600 in taxes, plus the 10 percent penalty of $1,500. Altogether, you will lose $5,100, leaving you with $9,000. That is quite a loss.

On the other hand, if you wait until you are 59½ to cash out your 401(k), and have $15,000 in it, you will come out much better. Although you would not pay any penalties on the money, you would still need to pay income tax—which would save $1,500. Some states will also tax you on your withdrawal. If you withdraw early, you are throwing that much money away.

Some Circumstances May Permit Early Withdrawals

Some situations enable you to take early withdrawals without having any penalties. There are limitations on them, depending on the reason. NerdWallet says that if you are a first-time homebuyer, you may get a 401(k) withdrawal for home purchase up to $10,000, but you may need to convert it to an individual retirement account (IRA) first.

A hardship withdrawal is another reason to get cash out of a 401(k). To get the money, you will have to qualify for it. Other possible situations include dividing the money after a divorce, being a domestic abuse survivor, school costs, becoming terminally ill, disaster relief, and more. A potential problem with a hardship loan is that you still may have to pay the 10 percent penalty.

Lose Credit Protection

Money that is in a 401(k) is safe from creditors. You cannot lose the money in a bankruptcy court. It is secure only while it is in the account, but SmartAsset says that when you withdraw it, a creditor may be able to get access.

It Can Take Time to Get Your Money

After you apply for a cash-out, you may wait several weeks to get your money. Your company, particularly smaller ones, may be required to limit withdrawals to once a year or to a quarter of a year. The details will be in the document for your 401(k).

Other Options to Get Money

Instead of getting money from your 401(k), you may want to consider these other options:

• Create an Emergency Fund

Many people younger than 34, RamseySolutions says, have already taken money out of their 401(k). If you create an emergency fund before you start contributions, you will not face many times where you need to touch your 401(k). Ideally, you want three to six months’ worth of expenses in the account and easily accessible.

• Life Insurance

If you have a whole life insurance policy, you may be able to get some or all the cash value to meet your needs. The longer you have the policy, the greater the cash value. If you take all the cash value, it will cancel the policy. Taking some of the cash value reduces the amount of coverage the policy offers. A term insurance policy does not have any cash value.

• A 401(k) Loan

Some 401(k) plans allow you to take out a loan. Forbes says it could be a good way to get cash if you can repay it. You may have a maximum of five years to pay back the loan. If you do not, you will pay taxes on the amount and the 10 percent penalty.

• Home-Equity Loans

Homeowners could get a home equity loan when they need money. You will have to pay interest, but it usually has a low-interest rate. An advantage of this kind of loan is that the interest is tax-deductible.

Less Cash in Retirement

The biggest loss you will experience when cashing out your 401(k) is the damage you do to your retirement savings. Not only can it take years to replace what you have withdrawn, but you will also lose out on the interest you could have gained during that time. It could end up being hundreds of thousands of dollars lost, even a million or more.

Other Options for Your Old 401(k)

There are some options if you do not want to leave your money with a previous employer. No requirement says you cannot leave it there. Because it is your money, it will remain available to you.

You can also roll it over to your new employer’s retirement account—either a new 401(k) or an IRA. If your previous account has considerable cash, you may want to roll it into a Roth 401(k). These accounts do not have required minimum distributions, but you must pay tax on the money you put into the account.

If you put your money into an IRA, Fool says an IRA will give you more investment options than a 401(k). The investment fees may also be lower.

Except in cases of emergency, cashing out your 401(k) is rarely a good idea except in cases of extreme emergency. Even then, you are likely doing so at the expense of a more comfortable retirement. Talk to a financial counselor if you need advice on what to do instead.

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