What’s one of the stupidest financial mistakes made by young adults–the decision to cash out of their 401(k)s. The USA Today reported that 60% of workers in their 20′s cash out their 401K when leaving or changing jobs.
The purpose of this article is to explain the 401K withdrawal rules are and discuss ways to avoid the penalties.
401K Withdrawal Taxes and Penalties
Here’s how the 401K withdrawal rules work. If you’re under 59 1/2 and withdrawal from your 401K, the amount is included in your gross income and accessed a 10% penalty.
For example, if your tax rate is 15% and you wanted to withdrawal $5,000, you would only receive 75% or $3,750 of your investment.
Avoiding 401k Withdrawal Rules | The Emergency Fund
The penalty for cashing out of your 401K, is great example of the benefits of an emergency fund. At a minimum, you need to have three months worth of expenses saved in a high interest savings account.
If layoffs are common in your field, you might think of having 6-8 months of expenses saved.
Avoiding 401k Withdrawal Rules | The Roth IRA
Did you know that you can withdraw contributions from a Roth IRA tax and penalty free? This is one reason, you might want to invest in an IRA over a 401K, if your employer doesn’t match contributions.
Avoiding 401k Withdrawal Rules | The Rollover
The best way to avoid the penalties for cashing out of your 401K is to rollover your 401K. There are multiple ways you can go about this and the optimal plan depends on your situation.
- You can rollover your old 401K to a new 401K. This option is only available though if you’re changing jobs.
- You can rollover your 401K into a Traditional IRA.
- You can rollover your 401K to a Roth IRA. Unfortunately, you have to pay income tax on the amount rolled over. However, for anyone who plans to be in a higher tax bracket in the future, this method will give them the highest after-tax return.
Cash Out of 401K to Pay off Credit Card Debt?
There is no simple solution to this problem. The answer is different for everyone.
If you’re contemplating this move, make sure you look at all other options before cashing out. This means that you should look at getting a second job, having a roommate or two, selling everything you can on eBay and Craigslist, or even moving back in with the parents.
If you haven’t exhausted all other options, you shouldn’t have this conversation.
401K Withdrawal Rules | Conclusion
The purpose is to show you that there are better options than cashing out of your 401K.
If you have any questions, please let me know in the comments.