Cashing out your 401k or taking a 401k loan: What you need to know

After years of regular contributions, a 401k plan through your employer may become one of your largest financial assets. In some cases, your employer may allow you to borrow against the funds in that plan, which may be another financial benefit to you. And in other cases, you might want to cash out your 401k or take a 401k financial hardship withdrawal. Here is some information to help you understand these 401k financial actions, some rules and tax implications.

401k loan

If you are considering a loan from your 401k plan, take a look at your employer’s plan to confirm if you can borrow from it. Here are some things to keep in mind.

• 401k loan limits. For many plans, the IRS says "the maximum amount that the plan can permit as a loan is either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less."
• 401k loan repayment rules. There are requirements for repayment of a 401k loan. First, the money has to be repaid, usually over a five-year period. If you quit, are laid off or if the 401k plan is terminated, the loan will typically become due within 60 days. This could be a big financial strain on you in addition to setting back your retirement saving. Another drawback is that if the loan is not repaid when due, then the loan balance will be treated as a withdrawal and may be subject to income tax as well as a 10% penalty tax if you are younger than 59½ years old.
• 401k loan interest. You'll have to pay the money back with interest, which in many cases may be lower than interest charged at a financial institution or credit cards. The good news is, the interest is credited to your 401k account, not to your employer, so you are paying the money back to yourself. Paying the loan back comes right out of your paycheck, too. So keep in mind that this will lower your take-home pay until the loan is paid back.

Cashing out your 401k

It may be tempting to take the big lump sum from your 401k when you leave your job and put it into your hands instead of rolling it over into a new 401k or IRA. But it’s important to understand the tax consequences if you decide to go that route.

401k rollover

When you leave your job, you can take your 401k with you. If you roll over your 401k balance into an IRA or your new employer's retirement plan, your money will continue to grow for retirement. A direct rollover literally means you will roll the money from one account to another, without the money being directly in your possession through the transaction.

401k taxes

Unless you are 59½ or older, you will generally have to pay income taxes on the funds withdrawn as well as a 10% penalty tax. That may make the withdrawal very expensive.

If you've left your employer and are over age 59½, you won't face the 10% federal tax penalty if you take your 401k balance as a taxable distribution. You will have to pay taxes on the total amount withdrawn unless part of the funds are Designated Roth Contributions. If you're still employed, the plan may limit withdrawals of your account balance even if you are age 59½ or older. Think about consulting with your tax advisor before taking a taxable distribution from your 401k plan.

Required minimum distributions (RMDs), beginning in April after the year you turn 72 (70½ if you were 70½ before January 1, 2020), will be necessary for any balance kept in the 401k plan.

401k hardship withdrawal

Some 401k plans may allow you to withdraw money from your retirement in the case of financial hardship. This type of hardship distribution needs to be due to a heavy and immediate financial need. And the amount to be withdrawn is limited to what is necessary to satisfy the need.

Some of the scenarios considered to be a financial hardship are:

• Medical bills for you or your family.
• Expenses related to the purchase of a primary residence, excluding mortgage payments.
• Tuition and related educational fees and costs for family.
• Expenses from a declared disaster.
• Payments necessary to prevent eviction from, or foreclosure on, a principal residence.
• Burial or funeral expenses for a spouse or dependent.
• Certain expenses for the repair of damage to your principal residence.

However, your employer may elect for all, some or none of these needs to be eligible for hardship withdrawals from the 401k plan. Also, if you receive a hardship withdrawal from the 401k plan, you may not be able to contribute to your account for six months. And amounts withdrawn can’t be repaid to your plan. These withdrawals will generally be subject to both income tax and a 10% tax penalty (for participants under age 59½), so consider it as a last resort for a serious emergency.

Unpredictable situations in life like leaving your job, having debt or experiencing an illness may prompt you to get a loan, cash out or take money from your 401k account. But consider it only after you've exhausted your cash savings accounts. You may be better off finding other sources of income or a different loan type. That way, you can help keep your retirement fund safe for its true purpose, retirement.