Factors to Consider Before Cashing Out a 401(k)

·5 min read

If you lose your job and have a 401(k) through your previous company, you may have the option of cashing it out. Sometimes employees choose to take the money instead of keeping it marked for retirement. However, before taking money out of the account, it pays to evaluate your reasons for the withdrawal, as well as the financial consequences that could result from the distribution.

Here are some factors to consider before cashing out a 401(k):

-- Calculate what you will pocket.

-- Consider if the funds are necessary.

-- Look into other ways to access cash.

-- Consider benefits and consequences.

-- Talk to an advisor.

Calculate What You Will Pocket

The amount you have set aside for retirement will drop significantly if you cash out. The withdrawal will be considered part of your taxable income. In addition, "if you are younger than 59 1/2, you will also pay a penalty of 10% on top of the ordinary tax on the money you cashed [out]," says Juan Carlos Cruz, founder of Britewater Financial Group in Brooklyn, New York. "The taxes and penalty alone may drastically reduce the money you accessed and create the need to withdraw even more to cover the taxes and penalties."

The IRS waives the penalty for certain hardships, including becoming disabled and approved disaster relief. Some plans allow for hardship withdrawals. "There are many different criteria you must meet," Cruz says. "Every company and plan will have their own rules." Talk to the plan's administrator or the human resources department to learn the full details of your plan.

[Read: How Much Should You Contribute to a 401(k)?]

Consider if the Funds Are Necessary

Ask yourself if the money is needed to help cover unexpected costs, and if so, evaluate the cause. "A financial emergency is a situation that, if not dealt with properly, can adversely affect your ability to live in your home, your health or your ability to pay for essential items," says Spencer Pringle, senior vice president for operations at Retirement Clearinghouse in Charlotte, North Carolina. Essential items might include basics such as food, daily transportation, utilities or paying off a defaulted loan.

Look Into Other Ways to Access Cash

If you're going through a tough financial situation, calculate the exact amount you need to cover expenses. "Even in a financial emergency, you may only require a portion of your 401(k) balance," Pringle says. "In most situations, you can cash out the amount you need to handle the emergency and keep the remaining amount invested."

Also look at other options for gathering the funds you need. You might be able to tap an emergency fund, take out a loan, refinance your mortgage or cut other monthly expenses to help cover the costs.

[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]

Think About Continuing to Invest

Instead of cashing out the 401(k), you may be able to leave it at your previous workplace. "By leaving the funds with the former employer, the 401(k) fees are generally low and investment choices are often broad," says Blake Christian, a partner at HCVT in Long Beach, California, and Park City, Utah.

If you don't leave the funds with your former company, there are other ways to keep the money set aside for retirement. "You can roll your existing plan into your new employer's plan if your new employer's plan permits such rollover contributions," says Steven J. Weil, president of RMS Accounting in Fort Lauderdale, Florida.

Another option involves putting the money into a rollover IRA. Rolling the funds into this type of account allows the money to grow on a tax-deferred basis. You will also be able to access the funds at a later point if you need them.

Consider the Consequences Versus Benefits of Cashing Out a 401(k)

Cashing out a 401(k) gives you immediate access to funds. If you lose your job and use the money to cover living expenses until you start a new job, an early 401(k) withdrawal might help you avoid going into debt. Once your income increases again, you can get back to saving for retirement.

However, the long-term consequences of cashing out can be steep. If you cash out your 401(k) now, you'll lose out on potential interest and earnings that would otherwise accumulate over time. Say you have $20,000 set aside. If you cash it out, you'll forfeit a significant amount of future earnings. Keeping $20,000 in a retirement account with a 10% return for 20 years could amount to $130,000.

Another factor to keep in mind involves your goals for retirement. If you plan to maintain your current lifestyle, you'll want to make sure you have enough saved to carry out your retirement goals. Leaving money in the account, rather than taking it out, could help you reach those financial goals.

[Read: New 401(k) Contribution Limits for 2021.]

Talk to an Advisor

Making a decision that is right for your financial situation is not always a straightforward process. You need to compare the urgency of your immediate needs to your ability to achieve your long-term goals. In some cases you may be able to boost income in other areas, such as taking on a side gig. You may also be able to cut expenses or tap an emergency fund.

"This is a complex area with many choices and possibilities," Weil says. Sit down with a financial or tax advisor to go over your available choices, and use the input to make a decision that meets your current and long-term needs.