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How Much Will The Tax Be on Cashing Out a 401K?

Avoid Being Socked by Uncle Sam when cashing out your 401K

401K plans were developed with the intent to defer paying taxes on income so that the funds grow more quickly and profitably in a tax free environment. 401K contributions are made pre-tax, which means that your taxable income is reduced by the amount of your contributions. Unfortunately, you cannot avoid paying taxes on your contributions or the interest you earn on it forever.

How Much Will The Tax Be on Cashing Out a 401K?

The tax you pay when cashing out a 401K depends on when and why you take out the money out. If you cash out your 401K in the year you turn 59 ½ or later, you pay federal and state taxes based on what your tax bracket is. All your sources of income will be included in the calculation of what your tax rate is no matter when you cash out your 401K, so if you are expecting a huge influx of cash one particular year, such as a profitable sale of stock, you may want to delay the distribution. Legally you do not have to start taking deductions until you are 70 ½ or the year of retirement, whichever is later, so with planning you can lessen your tax burden.

Cashing Out a 401K Early

If you cash out your 401K before you are 59 ½ you are subject to both income taxes and a 10% penalty. There are some exceptions to the penalty which include: total and permanent disability, medical expenses incurred that exceed 7.5% of your adjusted gross income, a divorce decree that requires you to give the money to your former spouse, separation from the company after the age of 55, and death. If the money had been in an IRA and you had used it as a first time home buyer or to pay for higher education for yourself, your spouse or a dependent, you would have been able to avoid the 10 % penalty on some of the income, but unfortunately these exceptions do not apply to 401K plans.

Delaying the Tax Burden When Cashing Out a 401K

If you are leaving your job, rather than cashing out your 401K, you can transfer the funds to the 401K plan of your new company or to a rollover IRA and they will remain protected in the deferred income environment.

Rather than taking an actual distribution from your 401K and being subject to the penalty and taxes, some companies allow you to take a loan out that is not treated as a distribution. You pay the loan back through payroll deductions, which are not tax deferred, but you are still avoid the 10% penalty and are still deferring the taxes due on the initial contributions and interest earned.

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How Much Will The Tax Be on Cashing Out a 401K?

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