In the majority of cases, you can’t cancel and cash out your 401(k) while still employed without paying a penalty. If something comes up and you need to access the cash in your 401(k) before retirement, the IRS does offer some exemptions to the penalty for situations it deems hardships. You can also take a loan from your 401(k) or roll your 401(k) money into an IRA and then withdraw it, although you may still be subject to penalties. Some employers even have 401(k) plans that offer in-service withdrawals without hardship requirements.
In the 1970s, the U.S. government enacted the Internal Revenue Service 401k Act to help supplement Social Security retirement funding. Lawmakers realized that in order for people to maintain lives similar to what they had while they were working, they needed an additional retirement fund. To ensure that people don’t “touch” funds that are meant for retirement, the IRS enacted penalties for those who withdraw money early (before age 59½).
However, knowing that life has a funny way of sneaking up on you with unexpected expenses, they did include some exceptions. So if you are still with the same employer and need access to your money, keep reading to learn about the various ways to access or cash out your 401(k) and the possible financial consequences.
How to access your 401(k) retirement plan while still employed
In general, the penalties for early distribution of a 401(k) are 10% plus applicable income taxes, depending on the structure of the 401(k) (traditional or Roth). The IRS may not penalize you for withdrawing from your 401(k) for the following reasons:
- You have an in-service withdrawal agreement
- You can prove financial hardship or hardship in general
- You have a baby (limit up to $5,000)
- You have become disabled
- You use it to pay a debt to the IRS
- You were the victim of a disaster, and the IRS has granted you relief
- You over-contributed to your 401(k) and are due money back
- You are a reservist in the armed forces and are called up
- You get divorced, and the court orders the 401(k) to be divvied up
All of these could technically be ways to access money while still employed, but most are not common. If you are still with the same employer but want to access your 401(k) with minimal penalties, you have three viable options:
- Withdraw money by proving hardship
- Take a loan against the 401(k)
- Roll it over to an IRA and access cash via the IRA
It’s important to note that the first two give you direct access to the money, whereas the third does not. Instead, you will be able to transfer the 401(k) to an IRA tax/penalty-free. If you need funds, you will then have to take money from your IRA, which could result in separate fees and penalties.
If you just want to cash out money and pay the penalty and taxes, keep in mind that liquidating your whole retirement account, especially before age 59½, could really hurt you when you need that money in retirement. So it should be an absolute last resort.
How to withdraw from a 401(k) by proving hardship
The IRS understands that life happens. Tuition fees are sky-high in the U.S., and health scares can happen to anyone. Therefore, the IRS allows you to withdraw money from your 401(k) without any major penalties in the following situations for an immediate and heavy financial need. The withdrawal is limited to the amount necessary to satisfy that financial need.
Note that the IRS assumes that the withdrawal will incur a 10% penalty. You must be able to prove your case, and it doesn’t guarantee that the IRS will grant you a penalty waiver.
Immediate and heavy financial need
The money can’t be for a bottle of fine Mendoza wine you bring on a date to impress someone. The IRS says the financial need must be “immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.” They call these types of needs “safe harbor” needs. Here is what the IRS defines as safe harbor needs:
- Medical expenses for the employee, the employee’s spouse, dependents, or beneficiary
- Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
- Tuition-related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary
- Certain expenses to repair damage to the employee’s principal residence
Limited to amount necessary
The IRS also stipulates that it will only grant a penalty-free withdrawal for hardships on the minimal amount necessary. This applies to the entire cost of the hardship, including taxes and tangential fees. The IRS also stipulates that the employee must exhaust all other means of paying for the costs, including insurance, liquidating assets, or even the ability to take a loan. Let’s look at an example of how this works below.
Ana’s heart surgery
Ana needs heart surgery, an expense that is well within the parameters of a medical-related hardship. The cost is $81,000, and Ana has $15,000 in her savings account and $10,000 in her property. Therefore, after exhausting all assets, Ana can qualify to withdraw exactly $56,000 from her account under the IRS hardship withdrawal parameters.
|Cost of operation||$75,000|
|Total in 401(k)||$120,000|
|Equity in property||$10,000|
|Total available to cash out||$56,000|
And what about the taxes? Roth vs. standard 401(k)
The difference between a Roth 401(k) and a standard 401(k) is how the contributions are taxed. If Ana were to have a Roth 401(k), her contributions would have been made after taxes, and thus she can withdraw the money under the hardship allowances tax-free. If, on the other hand, she has a traditional 401(k), then she will need to pay tax on the distributions. Here is what that can look like, assuming that Ana is in a 20% aggregate tax bracket.
|Total available to cash out||$56,000|
|Tax implications on a Roth 401(k)||$0|
|Tax implications on a traditional 401(k)||$11,200|
Remember, the hardship allowance lets you withdraw money from your 401(k) without the withdrawal penalty. The tax situation, though, is dependent on your 401(k), so double-check that before you make any moves.
Take a 401(k) loan
The second way to access cash from your 401(k) account while you’re still with the same employer is to take out a loan. A 401(k) loan is just like any other loan in which you have an asset backing up the loan (like a mortgage). However, instead of a house backing up the loan, your retirement savings back up the loan. You are required to pay the loan back WITH interest. This has two huge advantages.
- As you are taking on debt and technically not withdrawing the money directly, there are no tax implications, regardless of if your 401(k) is a standard 401(k) or a Roth 401(k).
- Again, as this is debt, you avoid the 10% early withdrawal penalty.
The loan is not unlimited, however. It is capped at either $50,000 or 50% of your account balance. The loan must be repaid after five years. It’s also worth mentioning that not all 401(k) programs offer the option of getting a loan.
Many financial advisors recommend this approach. Kendall Meade, a certified financial planner at SoFi, always tells her clients to go the loan route if possible. “I would recommend a 401(k) loan vs. an early withdrawal, even for hardship, for a couple of reasons,” she says. “One, with a loan, you are putting the money back into your 401(k). Two, even if you are able to avoid the 10% penalty for hardship withdrawals, you still have to pay income taxes on pre-tax funds.”
Meade adds, “It is important to keep in mind that if you decide to change jobs or get fired, you will have an accelerated timeline to repay a 401(k) loan. Otherwise, it could become a taxable event along with potentially incurring penalties.”
Example: Ana takes out a 401(k) loan
Below is an example similar to the one above, but this time, Ana is going to take a loan of $60,000 (50% of her 401(k) value) instead of withdrawing it directly.
|Total in 401(k)||$120,000|
|Total Ana can borrow from 401(k)||$60,000|
|Total in alternative assets||$25,000|
|Interest over 5 years at 5%||$16,577|
In this scenario, Ana can obtain $60,000, which is half of the value of her 401(k), as a loan. The loan can last up to five years, and assuming a 5% interest rate, she will need to pay an extra $16,577 in interest if she takes the loan for the whole five years. Herein lies the importance of paying the loan back in a smaller period of time. The $16,577 of interest is significantly higher than the $11,200 she would need to pay if she took a hardship distribution out of her 401(k). The loan also needs to be paid back. However, it might make sense if she only needs the money for, say, eight months, and thus doesn’t owe as much interest.
Roll money over to an IRA
The third way to “cash out” 401(k) funds isn’t really cashing out. Instead, you take your 401(k) money and roll it over into a private IRA plan, so you gain more control over your investment portfolio. Tatiana Tsoir, a CPA and tax expert, has seen this play out. “Generally, when people leave employment, they are advised to roll over their 401(k) into an IRA. And when the money is in an IRA, exceptions to the 10% penalty are much more liberal than for a 401(k). For example, a client of mine years ago was buying a house and he and his wife withdrew $10k each from their retirement accounts — 401(k) — for the down payment. Well, not only was it taxable, they paid $2k total in an early withdrawal penalty! Had they rolled it over (they had left their employment at the point of withdrawal), they would have saved 2k.”
In fact, if you need access to cash, you might be able to lessen the penalty by rolling over your 401(k) to an IRA and then withdrawing it. This penalty can also be waived for certain exceptions. In addition, the plan must be rolled over into the new IRA account within 60 days. If you fail to meet the 60-day threshold, then you might have to pay additional fees and taxes. However, you can also request to waive the 60-day requirement if your case is unique and you can prove it.
Example: Ana rolls her 401(k) into an IRA
|Ana moves into an IRA||$120,000|
|Ana withdraws from IRA||$56,000|
|8% withdrawal penalty||$4,480|
|Total value of Ana’s IRA after withdrawal||$59,520|
Above is an example of Ana rolling over her 401(k) into an IRA. As she is not over 59½ years old and hasn’t qualified for an exemption, she must still pay the penalty. But at 8% it’s more forgiving than the 401(k) early withdrawal penalty. This means that her new IRA will have $4,480 less in the account after the $56,000 she needed to withdraw.
Get help managing your 401(k)
If you’re faced with a big expense and thinking about withdrawing money from your 401(k), you might want to seek advice from an investment advisor before you take the plunge. A personal loan or home equity line of credit might be a better option. These advisors can help you decide.
Can I close my 401(k) and take the money?
Yes, but you will most likely have to pay a penalty as well as taxes on the income. You may be able to avoid paying penalties if you can claim hardship, roll the money into a private IRA, or take out a loan that you will pay back with interest. Some 401(k) plans will have in-service withdrawals that don’t need a hardship explanation and don’t penalize the 401(k)-holder. Of course, the rules are different if you are 59½ years old, as detailed above.
How do I remove money from my 401(k)?
If you would like to withdraw money, roll it over, or take out a loan, you will need to log into your employee retirement account online or contact the company that administers your 401(k). It may take a few business days to move money or process a loan application.
What is the penalty for withdrawing from a 401(k)?
There are certain situations in which you are allowed to withdraw funds for a 401(k) without a penalty while still employed. You might be able to get some fees waived, as mentioned above, but in many cases, you are looking at withdrawal penalties of 10%. You will also need to pay taxes, such as income taxes, on the money withdrawn, depending on how your 401(k) was structured. Again, this is for people below the age of 59½.
- In the majority of cases, you can’t cancel and cash out your 401(k) retirement money while still employed without paying a penalty. But if you need access to cash from your 401(k), there are ways to get it.
- The most common ways to access 401(k) money and minimize penalties are to make a withdrawal by proving hardship, take a loan against the value of your 401(k), or roll it over into a private IRA.
- The fee for an early withdrawal is usually 10%. Your need to pay income tax will depend on the structure of your 401(k) and if it is a Roth or standard 401(k).
- If you change jobs, you can receive your 401(k) as a lump sum or roll it over to a new employer’s plan or IRA. A lump sum will incur the requisite taxes and penalties.
View Article Sources
- Exceptions to Tax on Early Distributions – IRS.gov
- Hardships, Early Withdrawals, and Loans – IRS.gov
- 401(k) Resource Guide – Plan Participants – General Distribution Rules – IRS.gov
- Tax Rules for Early Withdrawals from Retirement Plans – SuperMoney
- 401k Plans: Complete Guide on 401(k) Retirement Plans – SuperMoney
- Ultimate Guide to Roth IRAs – SuperMoney
- What is an IRS Hardship Program and How Do You Apply? – SuperMoney
- 401k Withdrawals – SuperMoney