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What are the penalties for cashing
out my 401(k)?
Dear Money Matters,
I have a 401(k) from a previous job valued at about $40,000. I want
to withdraw from that 401(k) and cash it out without a rollover.
What penalties and taxes will I incur?
Gordon
Dear Gordon,
I have an answer you may not want to hear: Unless it's absolutely
necessary, don't do this. The reason is that, as you already know,
you're going to be hit with taxes and penalties galore. First, you
have an early withdrawal penalty of 10 percent -- that shears $4,000
off right there. Additionally, Uncle Sam taxes 401(k) withdrawals
as ordinary income -- how much depends on your tax bracket. Add it all up and your 401(k) could lose almost half its value by the time
you pocket the cash.
One issue I would raise is the reason you want to
cash out your 401(k). If, by chance, you don't like the investment
choices offered by your new 401(k) plan, you can always roll the
money into an IRA. This method gives you absolute freedom to choose
what to invest in and eliminates any penalties or taxes.
If you have a 401(k) at an existing job, you have another option: You
could borrow from your 401(k). It's not the perfect solution, but
it's a better choice than pulling the money out. Most plans offer
loan provisions, although some restrict how the money may be used
-- for instance, paying for school, medical emergencies and other
circumstances. You can generally borrow up to 50 percent of your
401(k)'s value, and the going interest rate -- set by the plan administrator
-- is usually lower than other sources of funds, such as credit
cards.
However, 401(k) loans carry significant drawbacks.
First, if you leave your job while the loan is outstanding, you
have to pay the money back quickly. If you don't, you're socked
with penalties and taxes. More importantly, borrowing from your
401(k) can significantly cut into your retirement savings. Since
the money isn't in your 401(k) account, you're missing out on significant
earnings. To illustrate: if you borrow only $5,000 and pay back
the loan over the course of five years, you can lose more than $48,000
in long-term value (this assumes a 10 percent annual 401(k) return,
7 percent interest on the loan and 35 years before retirement).
Even worse, fail to pay back the loan on time and your loss soars
to nearly $170,000.
Use Bankrate.com's "Should
I borrow from my 401(k) plan" calculator to see just how
much you may stand to lose.
Finally, a 401(k) loan can put a crimp in how much
you continue to put into your 401(k) -- after all, if you're focused
on paying back the loan, you may assume that you can't find the
money to keep your 401(k) contributions rolling. That, too, can
sock the eventual value of your account.
Bottom line -- if it's purely a matter of sink or
swim, a loan is the lesser of two evils. But I would urge you not
to touch your 401(k) if at all possible. The long-term implications
can be dire.
-- Posted: April 4, 2002
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