Cashing out a 401(k) early: the penalty, the exceptions, the withholding

Cashing out costs three separate things: income tax on the money, an additional tax on top, and a fifth of the balance withheld before it reaches you. The exceptions are real, but they are narrower than most people expect.

Three costs, not one

The first is ordinary income tax. The distribution is added to your income for the year you take it, on top of wages and everything else, and taxed at whatever rate that total lands in.

The second is an additional tax of 10%, charged on the part of the distribution that is includible in gross income. The law imposes it to discourage spending retirement funds on anything else, and it sits on top of the income tax rather than replacing it.

The third is not a tax at all, but it is the one you feel first. Most taxable lump sums paid directly to you out of an employer plan carry mandatory federal income tax withholding of 20%, even where you mean to roll the money over later, so the check that arrives is smaller than the balance you asked for. Withholding is a prepayment, not a settlement: if your rate plus the additional tax comes to more than was held back, the difference turns up as a balance due when you file.

Who the additional tax applies to

Generally it reaches distributions taken before age fifty-nine and a half from a qualified employee plan under section 401(a), such as a 401(k); a qualified employee annuity plan; a tax-sheltered annuity for public school or tax-exempt employees; and an individual retirement account or annuity.

One family of plans sits outside it. An eligible state or local government section 457 deferred compensation plan is generally not a qualified retirement plan for this purpose, so a distribution from one is generally not subject to the additional tax. The carve-out has a limit: amounts rolled into a 457 plan from a qualified plan do not take on that treatment, so a public employee who consolidated an old 401(k) should not assume the account is clear.

The exceptions worth knowing

The full list is longer, but these are the ones that come up. Separating from service with that employer after reaching age fifty-five. Being totally and permanently disabled. Being terminally ill. Payments made to a beneficiary or an estate after the owner's death. A payment to a spouse or former spouse under a qualified domestic relations order. Distributions up to the deductible medical expenses you have above seven and a half percent of adjusted gross income, whether or not you itemize. A series of substantially equal periodic payments over life expectancy. A distribution caused by an IRS levy on the plan. Qualified birth or adoption distributions.

Check which kind of account the money is leaving, too: some of these reach employer plans only, such as separation at age fifty-five and a domestic relations order, and some reach individual retirement arrangements only.

Read carefully what an exception does. It removes the additional tax, and only that; the income tax stays where it was, so an exception makes a cash-out cheaper without making it cheap.

Hardship is not an exception

A hardship withdrawal is permission from the plan to take money out for a pressing need. It waives nothing on the tax side. Hardship does not appear among the exceptions to the additional tax, and a hardship distribution cannot be rolled over, so the sixty-day escape below is closed to it.

The sixty-day escape

If the money has already gone, the decision is often reversible. Most pre-retirement payments from a plan or an individual retirement arrangement can be rolled over into another one within sixty days, and an amount rolled over is not taxable, so neither the income tax nor the additional tax touches it.

The withholding is what breaks this. The plan kept a fifth, so only the rest arrived. To roll the whole distribution you have to make up the withheld portion out of other money; whatever you do not replace stays a taxable distribution, with the additional tax on top if no exception applies. Missing the sixty days generally ends the option, although the IRS may waive the deadline for reasons beyond your control.

The way to avoid all of this is a direct rollover, where the money moves from plan to plan, or plan to arrangement, without passing through you. Withholding does not apply, and a check written out to the receiving plan counts as direct even when it comes to your address.

Small balances move without you

A plan may also move money without being asked. If you no longer work for the employer and the account is small, the administrator may deposit it into an individual retirement arrangement in your name when you neither take it nor elect a rollover, and a very small balance may be paid straight to you, less withholding in most cases, without your consent. The sixty-day window is open either way.

What it actually costs, in words

Empty an old plan and the sequence runs like this: a fifth never reaches you, the rest arrives and gets spent, and next April the whole distribution joins your income, with tax at your rate and the additional tax on top unless an exception fits. If your other income is high enough the withholding does not cover that, and the shortfall can bring an underpayment charge; quarterly estimates and why you owe this year both cover that side, and the distribution arrives on Form 1099-R coded to say which rule the plan applied. The last cost has no line on the return: the balance stops compounding for the rest of your working life.