Yes, but it may not be such a great idea…
Reviewed by Anthony Battle
You can make a 401(k) withdrawal in a lump sum, but is it a good idea to do so? Usually, the answer to that is no. Tax-deferred retirement plans, such as 401(k)s, are designed to provide income during retirement.
In most cases, if you make any withdrawal and are younger than 59½, you’ll pay a 10% early withdrawal penalty in addition to income taxes on the amount you withdraw.
Here are some of the options available to withdraw a lump sum from your 401(k) and what you need to consider.
Key Takeaways
- You can make a 401(k) withdrawal in a lump sum, but in most cases, if you do and are younger than 59½, you’ll pay a 10% early withdrawal penalty in addition to taxes.
- You can take a 401(k) loan against your balance but will be subject to penalties if you default.
- A hardship withdrawal can give you retirement funds penalty-free, but only for specific qualified expenses and you’ll still owe taxes.
- You are limited to the lump-sum withdrawal options your plan allows.
Lump-Sum Withdrawal Options While Employed
Some companies automatically enroll eligible workers in a 401(k)—they can opt-out—while others let employees choose if and when they participate. Employers often rely on a plan sponsor to educate employees on the investments, benefits, and contribution limits of a 401(k) plan.
The majority provide sufficient direction to employees when they begin contributing to the plan, but they often fall short of providing useful information when employees change jobs, retire, or need to withdraw money from their plans.
If you want to avoid the 10% tax penalty when making a lump-sum withdrawal while still working and under 59½, you have two main options. The two most common lump-sum withdrawal provisions come in the form of a hardship withdrawal or a loan against your 401(k) balance. Of course, a loan isn’t a true withdrawal as you’ll have to pay it back to avoid the penalty. It may not be recommendable in the vast majority of cases, but you can of course also withdraw without hardship and pay the penalty. Some employers’ plans may restrict lump-sum withdrawals while you are still employed with them.
Hardship Withdrawals
A hardship withdrawal is a lump-sum withdrawal based on financial need that you do not need to repay. A hardship withdrawal must meet the IRS’s criteria, such as covering crippling medical expenses, to avoid paying the 10% early withdrawal penalty. You’ll still owe income taxes on the amount withdrawn.
On March 27, 2020, President Trump signed a $2 trillion coronavirus emergency relief bill, called the CARES Act, into law. It allowed those affected by the coronavirus pandemic in 2020 to take a distribution of $100,000 or less without the 10% penalty those younger than 59½ normally owe.
Account owners also have three years to pay the tax owed on withdrawals, instead of owing it in the current year. Or, they can repay the withdrawal during that period to a 401(k) or IRA plan and avoid owing any tax—even if the amount exceeds the annual contribution limit for that type of account.
There is another case where plan holders can make a lump-sum withdrawal from their plans without incurring the 10% penalty. According to Section 113 of the Setting Every Community Up for Retirement Enhancement (SECURE) Act—signed into law in December 2019—new parents are allowed to withdraw a maximum of $5,000 from their plans penalty-free to pay for adoption or birth expenses.
401(k) Loans
A 401(k) loan is typically paid back through paycheck deferrals over time. Except under the 2020 law, the loan is capped at a certain percentage of your total 401(k) balance; the IRS allows up to 50% and a maximum of $50,000 of vested funds, whichever is less.
If you have a 401(k) plan with the ability to take out a loan, you can withdraw the funds tax-free. Of course, you will have to pay them back, but this allows you to borrow from your 401(k) account and pay yourself back the interest and principal over time.
Note
The CARES Act doubled the amount of 401(k) money available as a loan to $100,000 in 2020, but only if you had been impacted by the COVID-19 pandemic.
Options When You Leave an Employer
Lump-sum withdrawal options are not as limited when you leave an employer for another job or if you retire. You can take a penalty-free lump-sum distribution from a previous employer’s 401(k) plan up to the total vested account balance. After placing a distribution request, the plan sponsor or custodian sends a check directly to you, and the account is closed with the custodian.
If you have a Roth 401(k) balance, no taxes are withheld—with traditional pre-tax traditional 401(k) plans, sponsors withhold taxes from the balance before cutting the check. In either case, if you are under 59½, you are subject to a 10% tax penalty.
You can avoid taxes and penalties by rolling over the lump-sum withdrawal into an individual retirement account (IRA). In this case, the check is made out to the custodian of the IRA, not to you—although it should be marked “for the benefit of” you. As you never received the funds in cash, you are not taxed.
If you’re switching jobs, another option is to roll over the 401(k) into the 401(k) at your new employer, if that new plan allows for this option. Review all your choices carefully before you decide.
Note
Funds withdrawn from your 401(k) must be rolled over to another retirement account within 60 days to avoid taxes and penalties.
Special Considerations for Withdrawals
The greatest benefit of taking a lump-sum distribution from your 401(k) plan—either at retirement or upon leaving an employer—is the ability to access all of your retirement savings at once. The money is not restricted, which means you can use it as you see fit. You can even reinvest it in a broader range of investments than those offered within the 401(k).
Since contributions to a 401(k) are tax-deferred, investment growth is not subject to capital gains tax each year. Once a lump-sum distribution is made, however, you lose the ability to earn on a tax-deferred basis, which could lead to lower investment returns over time.
Tax withholding on pre-tax 401(k) balances may not be enough to cover your total tax liability in the year when you receive your distribution, depending on your income tax bracket. Unless you can minimize taxes on 401(k) withdrawals, a large tax bill further eats away at the lump sum you receive.
Finally, having access to your full account balance all at once presents a much greater temptation to spend. Failure in the self-control department could mean less money in retirement. You are better off avoiding temptation in the first place by having the funds directly deposited in an IRA or your new employer’s 401(k) if that is permitted.
How Much Will I Get If I Cash Out My 401(k)?
If you cash out the entirety of your 401(k) you will get whatever is left over after taxes (and penalties if you are younger than age 59.5). So, if you were 60 years old and had $1,000,000 in your 401(k), and you were in the 25% tax bracket, you would receive $750,000. If you were, say age 50 and in the same tax bracket, you would be subject to an additional $100,000 early withdrawal penalty, leaving you with $650,000.
What Counts As a Hardship Withdrawal?
Hardship withdrawals can allow you to take out 401(k) money without paying the 10% early withdrawal penalty (but you’ll still owe the deferred tax liability). Qualified reasons include certain medical expenses, qualified education expenses, the birth or adoption of a child, purchasing a first home, funeral expenses, and permanent disability.
Can I Take My 401(k) in Installments?
Yes. In retirement, you can withdraw only as much as you need to live, and allow the rest to remain invested. You can also choose to use your 401(k) funds to purchase an annuity that will pay out guaranteed lifetime income.
Read the original article on Investopedia.