When You Prematurely Cash in Your 401K- Ouch

At some varying points in your life, some strange things may occur- It’s called life. Many of these strange happenings come at the most unexpected times, with some sort of financial emergency attached to them. This emergency can cost typically more than a few hundred dollars, or maybe even a few thousand. Sometimes you even consider cashing in all or part of your 401K.

While your 401K is, and will always be, your money, taking a withdrawal from it can have quite a few interesting fees and penalties that coincide with the process.

Your individual plan may or may not have a withdrawal option for you.  You may not have enough time and/or money vested into the program to warrant such a feature.  In any case, be sure to contact your plan’s administrator to see if a withdrawal is even a viable option for you to consider.

Hardship Withdrawals

Hardship withdrawals are the most popular type of withdrawal, other than those at retirement.  To qualify for a hardship withdrawal, your reasons must fall within the IRS’ safe harbor regulations, having an “immediate and heavy financial need” with “no other resources reasonably available”. With this in mind, the IRS has deemed the following “reasonable means of hardship”:

  • Costly medical expenses incurred by you , your spouse, and/or your dependants.  Specific guidelines are set for your protection, so be sure to have your reason ready.
  • Funds may be taken out to avoid eviction or foreclosure of one’s primary home.
  • To purchase a primary home (not to make a mortgage payment obligation)
  • To pay for post secondary education (college) expenses for you, your spouse, and/or dependants.

If your “financial emergency” does not fit into any of these descriptions, you might want to research the possibility of taking out a loan against your 401K.

If your current financial crisis does fit nicely within these IRS guidelines, there are a few additional points of interest you might want to consider before signing the necessary paperwork:

  • Two things are guaranteed in life- death and taxes, the latter of which brings us to this point. All monies put into a 401K are tax deferred, not tax free, so you eventually have to pay the required taxes on them.  For the majority of us, this point comes when our money is withdrawn, whether or not we are at retirement age.  To be safe, assume that 20% of your withdrawal will be held back for federal taxes. State and local taxes are completely different issues.  The Economic Growth and Tax Relief Reconciliation Act of 2001 forbids any and all hardship withdrawals to be rolled over into a type of IRA or 401K and are not subject to the 20% federal income tax withholding as it is with other means of taking money out of your 401K. This doesn’t at all mean that you aren’t responsible for the taxes on the funds, it just means you aren’t responsible for it until tax time rolls around next year.
  • An early withdrawal penalty of 10% is another take-away from your cashed-in 401K, but only if you are under the age of 59 ½.  Hardship withdrawals do not usually constitute a penalty-free withdrawal. However, there are a few circumstances in which they do, such as certain medical bills, if you become disabled (as defined by the IRS), or if you leave a company (complete with your 401K) in the year that you reach 55 or more years of age.

If you are uncomfortable regarding what your options are, or maybe what’s your best choice at the time, contact your tax/financial advisor or 401K plan administrator to help you decide on the best course of action.

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