Establishing a retirement savings plan during your working years is a necessary part of comprehensive financial planning, and the burden of savings rests on the shoulders of employees.
To that end, contribution-based retirement savings plans are a common benefit offered by employers, typically in the form of a 401(k) plan. Some companies automatically enroll eligible workers in a 401(k) (they can opt-out) while others let employees choose if and when they will participate.
- You cannot completely cash out a 401(k) that you have with your current employer.
- You can take a 401(k) loan against your balance, but it may be subject to taxes and penalties.
- You can completely cash out a 401(k) that you had with a previous employer.
Employers often rely on a plan sponsor to educate employees on the benefits and limitations of a 401(k) plan. These sponsors, also known as plan custodians, are tasked with educating eligible employees on the benefits of the plan, the investment selections available, and the contribution limits.
Lump-Sum Withdrawal Options While Employed
The majority of employers and 401(k) plan sponsors provide sufficient direction to employees when they begin contributing to the plan, but they often fall short of providing useful information when employees change jobs, retire, or need to withdraw money from their plans.
If you currently work for an employer with an active 401(k) plan, you are limited to the lump-sum withdrawal options indicated in the original plan document. This generally means that, while you may access a portion of it, you cannot simply cash it out. The two most common lump-sum withdrawal provisions come in the form of a loan against your 401(k) balance or a hardship withdrawal. Both types of withdrawals may be subject to tax and penalties.
A hardship withdrawal is a lump-sum withdrawal based on financial need that you do not need to repay. A 401(k) loan is paid back through paycheck deferrals over time. The loan is capped at a certain percentage of your total 401(k) balance, typically 50%.
“If you have a 401(k) plan with the ability to take out a loan, you can withdraw the funds tax-free,” says Kirk Chisholm, a wealth manager at Innovative Advisory Group in Lexington, Mass. “Of course, you will have to pay them back, but this allows you to borrow from your 401(k) account and pay yourself back the interest and principal over time.”
If you take a lump-sum withdrawal from a 401(k) and are younger than 59½, you are subject to a 10% tax penalty for early withdrawal.
Options When You Leave an Employer
Lump-sum withdrawal options are not as limited when you leave an employer for another job or if you retire. You can take a lump-sum distribution from a previous employer’s 401(k) plan up to the total vested account balance. After placing a distribution request, the plan sponsor or custodian sends a check directly to you, and the account is closed with the custodian.
If you have a Roth 401(k) balance, no taxes are withheld; with pre-tax (traditional) 401(k) plans, sponsors withhold taxes from the balance before cutting the check. In either case, if you are under 59½, you are subject to a 10% tax penalty for what the Internal Revenue Service considers to be an early withdrawal.
You can avoid taxes and penalties by rolling over the lump-sum withdrawal into an individual retirement account (IRA). In this case, the check is made out to the custodian of the IRA, not to you (although it should be marked “for the benefit of” you). As you never received the funds in cash, you are not taxed.
Considerations for Withdrawals
The greatest benefit of taking a lump-sum distribution from your 401(k) plan—either at retirement or upon leaving an employer—is the ability to access all of your retirement savings at once. The money is not restricted; you can use it as you see fit. You can even reinvest it in a broader range of investments than those offered within the 401(k).
Contributions to a 401(k) are tax deferred, and investment growth is not subject to capital gains tax each year. Once a lump-sum distribution is made, however, you lose the ability to earn on a tax-deferred basis, which could lead to lower investment returns over time.
Tax withholding on pre-tax 401(k) balances may not be enough to cover your total tax liability in the year when you receive your distribution, depending on your income tax bracket. Unless you can minimize taxes on 401(k) withdrawals, a large tax bill further eats away at the lump sum you receive.
Finally, having access to your full account balance all at once presents a much greater temptation to spend. It can be a challenge to implement self-control. Failure in that department could mean less money in retirement. You are better off avoiding temptation in the first place.