It’s a basic but all too common question posed on financial blogs like this one: “I just left my job. I have $1,000 sitting in my old 401(k) and I’m short on cash. Can I just cash out the 401(k)?”
Today we answer this simple question.
Just because you can cash out your 401(k) doesn’t mean you should
Technically, yes: After you’ve left your employer, you can ask your plan administrator for a cash withdrawal from your old 401(k). They’ll close your account and mail you a check.
But you should rarely—if ever—do this until you’re at least 59 ½ years old!
Let me say this again: As tempting as it may be to cash out an old 401(k), it’s a poor financial decision. That’s because, in the eyes of the IRS, cashing out your 401(k) before you are 59 ½ is considered an early withdrawal and is subject to a 10% penalty on top of regular income taxes. Oh, yes, that’s another thing: Since the 401(k) is funded with pre-tax money, you also have to pay taxes on it when you cash out.
In most cases, your plan administrator will mail you a check for 70% of your 401(k) balance. That’s your balance minus 10% for the withdrawal penalty and 20% to cover federal income taxes (depending on your tax bracket, you may owe more or less when you file your return).
It’s financially prudent to save for retirement and leave that money invested. But paying the 10% early withdrawal penalty is just dumb money — it’s equivalent to taking money you’ve earned and tossing it out the window.
What about my current 401(k)? Can I access that money at any time?
You cannot take a cash 401(k) withdrawal while you are currently working for the employer that sponsors the 401(k) unless you have a major hardship. That being said, you can cash out your 401(k) before age 59 ½ without paying the 10% penalty if:
- You become completely and permanently disabled
- You incur medical expenses that exceed 7.5% of your gross income
- A court of law orders you to give the funds to your divorced spouse, a child, or a dependent
- You retire early in the same year you turn 55 or later
- You are permanently laid off or terminated, you quit, or you retire and have established a payment schedule of regular withdrawals in equal amounts for the rest of your expected natural life.
Additionally, you can cash out your 401(k) and pay the 10% penalty if you need funds for certain financial hardships and have no other source of funds. These hardships include:
- The purchase of your primary home
- Higher education tuition, room and board, and fees for the next twelve months for you, your spouse, or your dependents or children
- To prevent eviction from your home or foreclosure on your primary residence
- Tax-deductible medical expenses that are not reimbursed for you, your spouse, or your dependents
- Other severe financial hardship
Even if you meet these requirements, cashing out your 401(k) should always be seen as an absolute last resort.
Compound interest only works if you leave the money alone
We talk a lot at Money Under 30 about compound interest. It’s what makes a comfortable retirement possible for most of us. When you cash out your 401(k) early, you’re not just subtracting that balance from your eventual retirement fund. Rather, you’re deducting your balance, plus any interest your balance will earn over the next few decades, plus the interest the interest would earn! Taking a few hundred bucks now could cost you thousands down the road. Not to mention that you immediately lose almost 30% of your balance to taxes and fees.
It might feel like a small windfall now, but over the long term, you’re taking yourself to the cleaners.
Most retirement funds are set up to allow your money to grow with few interruptions: Hence why the money you put into a 401(k) isn’t taxed, why the interest you earn while your money is in the 401(k) isn’t taxed, and why it’s relatively hard to remove money from your account until you’re close to retirement age.
While we know it’s tempting to take that small pot of cash, we urge you to resist. And once you’ve gotten a new job, you should roll your old 401(k) into your new employer’s plan. That’ll take away the temptation entirely.
Summary
When you’re in a tight spot and need cash, your old 401(k) can look like a convenient pot of gold. But the long-term damage to your retirement fund isn’t worth the temporary boost to your bank account.
