Changing jobs, retirement, experiencing financial hardship or other life circumstances may cause you to consider cashing out your 401(k). Here is an easy-to-understand guide on the pros and cons of cashing out your 401(k) at age 40, 55 and 70.
What is a 401(k)?
A 401(k) plan is a retirement account offered by many employers. It’s a “defined contribution” retirement account, which means employees can contribute to their 401(k) through automatic payroll withholding and employers can routinely match some or all of the employee’s contributions. The Internal Revenue Service (IRS) sets limits on the amount an employee and employers can contribute to the 401(k) account, and periodically adjusts that amount for inflation. For example, in 2020 the IRS will increase the allowable contribution amount to $19,500 for basic contributions, the catch-up amount will be increased to $6,500 and the cap (including employer contributions) to $57,000 – $63,500 for people aged 50+.
It’s important to note the 401(k) contributions and earnings are not taxed until the money is withdrawn from the account.
The downside of cashing out a 401(k)
The decision to cash out a 401(k) should not be taken lightly, as it can have significant financial impact. Withdrawing from a 401(k) account before age 59 ½ can result in paying penalties up to 20 percent of the value, plus taxes owed on the money withdrawn. The amount withdrawn also counts toward personal income and may cause a bump into a higher tax bracket, making the net gain even smaller. Also, you are eliminating the potential for future growth if the money was left in the 401(k) account.
Changing jobs? You don’t need to cash out your 401(k)
If you’re simply changing jobs, there are three options to consider before cashing out your 401(k) plan without maximizing the benefit of the retirement account. Better options include;
- Leave your 401(k) with your former employer
- Move your 401(k) to your new employer
- Roll your 401(k) to an IRA managed by a financial services firm that offers a wider range of investment choices than your new employer’s plan.
The IRS had strict rules regarding rollovers, and it is wise to consult with a financial advisor to ensure you are adhering to the rules and avoiding any tax penalties.
Pros and cons of cashing out at age 40, 55 and 70
At any age, it’s important to look at your total wealth management. Withdrawing from your 401(k) at age 40 makes the withdrawal amount subject to early withdrawal penalties, tax penalties, and puts you at risk of being bumped into a higher tax bracket. If considering a 401(k) withdrawal at this young age, first talk to a financial advisor and strongly consider other options to address whatever life circumstance you are facing.
At age 55 it is possible to withdraw from a 401(k) without penalty under certain circumstances. The “Rule of 55” allows early withdrawals without penalty from your 401(k) account if you retire, quit or get fired between age 55 and 59 (or age 50 for public safety employees). This only applies to a 401(k) account with your current employer, and does not apply to 401(k) accounts not rolled over from previous employers.
At age 70, the 401(k) beneficiary is well-poised to reap the rewards of their investment. In fact, most investors are required to start making withdrawals from 401(k), IRA or other retirement plans after reaching the 70 ½ year old threshold.
How do I decide what’s best for me? The total wealth management approach
When making any major financial decision, don’t look at one small piece of financial well-being in isolation. Instead, take a holistic view of your financial health. For example, cashing out a 401(k) at age 40 might relieve the short-term pain of a credit card bill or car loan, but it would cause long term damage to the retirement savings you’ve worked so hard to accumulate.
The total wealth management approach looks at every aspect of your financial life – such as your 401(k) savings, investments, stock and bonds – and also looks at how you’re protecting your home, car and personal health. It also considers life insurance and a will, ensuring you will pass your value along to the people you love – and wraps it all in a package that addresses taxation and maximizes your happiness and well-being. Because true wealth comes from achieving peace of mind.
The experienced team of investment advisors at Wickham Financial & Insurance Services works closely with clients at every level of the wealth and career spectrum. We will help you take a holistic view of your financial position, evaluate all your options, make informed decisions and guide you through the process of total wealth management.
Any information provided has been prepared from sources believed to be reliable but is not guaranteed, does not represent all available data necessary for making investment decisions and is for informational purposes only.