Tax Penalty for Cashing Out a 401(k)

Dear 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 ½ are subject to a 10% 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% early withdrawal penalty:

Qualified distributions up to the amount you paid for unreimbursed medical expenses during the year, minus 10% of your adjusted gross income for the year.

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% 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% penalty, the future value of the $10,800 balance will only be $23,664 in 20 years, again assuming a modest 4% 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!

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