Cashing Out 401k

By Harper Willis

If you recently left a job where you had savings in a 401(k) plan, you should transfer those assets to your new employer’s plan or, if you don’t have a new job lined up, to an IRA. Why not simply take the cash? After all, you may need it to finance your transition. Trouble is, you’ll wind up losing a significant portion of your savings to taxes and penalties.

In fact, the biggest mistake you can make during the rollover process is to cash out your 401(k) plan instead of doing a direct rollover.

If you cash out, your employer will write you a check for the amount in your account minus 20%, which is withheld for taxes. In addition, the IRS will charge you any additional income tax (based on your income tax rate) due on the full amount, as well as a 10% early withdrawal penalty if you’re under age 59 ½.

Here’s how the numbers might look. Say you have $100,000 in your account. You want to withdraw the full amount. Your employer withholds $20,000, leaving you $80,000 in cash. Then you have to pay the remaining federal and state tax on the full $100,000. If your combined tax rate is 35%, the total tax (including the amount withheld) comes to $35,000, which leaves you only $65,000 in cash. Add an early withdrawal penalty of $10,000 (10% of the initial $100,000) and you’re left with $55,000.

The other problem with cashing out: you’ll give up future tax-deferred growth in your 401(k). In doing so, you’ll lose one of your greatest allies in your battle for a secure financial future.

Some workers cash out their 401(k) with the intention of moving the money into their new employer’s plan—but that’s not a great idea. True, you have 60 days to deposit 100% of the amount you held in your original 401(k) to your new account before taxes and penalties kick in. The problem is, because your employer will have withheld 20%, you’ll have to find a way to make up the difference out of pocket or from another account. You’ll be charged taxes and penalties on however much your new account falls short of the original amount.

You can avoid that problem by asking your old employer to transfer the money directly into your new account in the form of a direct rollover. You can obtain the necessary forms from your former employer. Sometimes you’ll need to open an account with your new employer before submitting the rollover request.