Tax penalty for cashing out a 401(k)

Judy O'ConnorDear Tax Talk,
I was recently terminated from a 14-year position. I had a 401(k) and now must decide whether to cash it out or put it in an individual retirement account. I could really use the money as I have four children and unemployment has been a long process. Also, the state of Massachusetts is of no help because it actually counts the 401(k) as income! What type of tax penalty would I face for withdrawal? I am 39, unemployed and soon to be broke. The amount of my 401(k) is $20,805.
-- Jill

Dear Jill,
You are correct; any distributions from 401(k) plans are included in your taxable income. In addition, any distributions made before you reach the age of 59 1/2 are subject to a 10 percent additional tax penalty unless you meet one of the various exceptions that are allowed by the Internal Revenue Service.

The exceptions are listed on the instructions for IRS Form 5329. There are 12 different exceptions allowed, and in looking at your situation there are some that may be available to you. If you take any distributions for these reasons, then you will not be subject to the 10 percent early withdrawal penalty:

  1. Qualified distributions up to the amount you paid for unreimbursed medical expenses during the year, minus 10 percent of your adjusted gross income for the year.
  2. IRA distributions made to an unemployed individual for health insurance premiums.

While it may seem tempting to dip into your 401(k), I strongly advise rolling over as much as you can into an IRA. Let's say you contribute nothing more to your 401(k) ever. In 20 years, the future value of that $20,805, assuming a modest 4 percent annual growth, will be approximately $45,575. If you take out $10,000 now, not only will you pay regular income tax plus possibly the 10 percent penalty, the future value of the $10,800 balance will only be $23,664 in 20 years, again assuming a modest 4 percent annual growth.

The penalties are in place as a deterrent to making these kinds of distributions. The government does not want you to withdraw $10,000 today that could potentially be worth a lot more in the future when you are ready to retire. Please try to take advantage of any and all governmental programs available to you during this difficult time.

Good luck!

Ask the adviser

To ask a question on Tax Talk, go to the "Ask the Experts" page and select "Taxes" as the topic. Read more Tax Talk columns.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

Bankrate's content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate's Terms of Use.


Show Bankrate's community sharing policy
          Connect with us
Product Rate Change Last week
30 year fixed 3.84%  0.04 3.80%
15 year fixed 3.06%  0.03 3.03%
5/1 ARM 3.14%  0.01 3.15%
View Rates in your area Next
Product Rate Change Last week
30 year fixed refi 3.91%  0.05 3.86%
15 year fixed refi 3.16%  0.08 3.08%
10 year fixed refi 3.13%  0.01 3.14%
View Rates in your area Next
Product Rate Change Last week
60 month used car loan 2.68%  0.03 2.65%
48 month used car loan 2.76%  0.11 2.87%
60 month new car loan 3.11% --0.00 3.11%
View Rates in your area Next
Product Rate Change Last week
1 Year CD 1.07% --0.00 1.07%
2 Year CD 1.18% --0.00 1.18%
5 Year CD 1.76%  0.01 1.77%
View Rates in your area Next
Product Rate Change Last week
Balance Transfer Cards 15.86% --0.00 15.86%
Cash Back Cards 16.37% --0.00 16.37%
Low Interest Cards 11.10% --0.00 11.10%

Our tax expert Kay Bell provides resourceful tips and advice to help you stay prepared for filing.



Kay Bell

Tax system concerns aren’t personal

A recent poll found that most people aren't too upset about their own tax bills. However, they do worry that corporations and the wealthy aren't paying their fair share of taxes.  ... Read more

Partner Center

Connect with us