Nearly 50 million Americans have 401k accounts, which are retirement savings accounts that match your monthly, pre-tax contributions with contributions from your employer (in most cases). The money then grows in your investment portfolio and can be withdrawn, generally, once you hit the age of 59 ½.
A 401k is tax advantageous because you can invest with pre-tax dollars, meaning you have more money up front to put into your portfolio. Interest accumulates at a greater rate and your wealth builds faster than it would if you used post-tax dollars. Of course, you have to pay taxes on any withdrawals, but you don’t have to cross that bridge until you actually begin withdrawing money .
How much will you have to pay in taxes if you cash out your 401k? This assumes you’re cashing it out before the age of 59 ½, but for comparison’s sake, we’ll run the numbers for all scenarios – including being able to get your money tax-free once you hit the age of 70 ½.
Tax Laws and 401k Plans
The IRS is pretty clear about taxes and 401k plans: If you withdraw money or cash out your 401k, you will pay taxes on it.
How much really depends on your individual circumstances.
For starters, everyone is in a tax bracket. The tax bracket can be as low as 10% or as high as 35% for those making at least $388,350 and filing as single. That tax bracket is applied to not just your withdrawal amount, but your entire income for that year.
Here’s an example. If you withdraw, say, $5,000 from your 401k plan when you turn 59 ½, taxes aren’t levied just on that $5,000. If that were the case, you’d only have to pay 10% in federal taxes, plus your state taxes (unless you’re lucky enough to live in a state like Florida that doesn’t have income tax). That’s not the case, though; you add the $5,000 to the rest of your income that year to calculate your new taxable income base.
This can result in you being bumped up to a higher tax bracket. Let’s say that year, you made $35,000 – which puts you in the 15% tax bracket. With the $5,000 withdrawal, your gross taxable income grows to $40,000, which is in the 25% tax bracket for a single filer.
So, instead of paying 15% on $5,000, which would be $750, you’d pay taxes on $40,000. You calculate that by taking the first $8,700 of your income and multiplying it by 10% ($870). Then, take $35,350 (the upper limit of the next tax bracket, 15%) and subtract $8,700 to get $26,650, and multiply that by 15% to get $3,997.50. Then, take the rest – $4,650 – and multiply it by 25% to get $1162.50. The total amount in taxes, then, would be $6,030.
That is if you withdraw when you’re supposed to.
Cashing Out Your 401k
The tax implications of cashing out your 401k before the 59 ½ mark could be more severe, plus they are accompanied by penalties.
Taxes will be levied on the entire amount, so that will dramatically impact your gross taxable income for that year. If you were making $35,000 and you cash out an account that has $100,000 in it, you’d be paying 28% on roughly $44,350, which would result in taxes of $12,418 for that section alone.
On top of that – in addition to state income taxes – you’d pay a stiff 10% penalty for the entire amount to the IRS. So, for an account balance of $100,000, you’d pay $10,000 in taxes that year.
The end result is that your 401k balance would dwindle significantly, which is why it is highly recommended to avoid cashing out your 401k unless you absolutely have to for an emergency. Otherwise, leave it in so it can grow and accumulate through investments over time until you reach the age of 59 ½ and can withdraw it penalty-free. And, if you wait until 70 ½, you can withdraw your money without paying any taxes at all.
Options for Your 401k
There are two options that you could take instead of cashing out. One is to borrow money against your 401k. You have to pay it back within five years, but it’s your money that you’re paying back – so essentially you’re paying back the principal plus interest to yourself. It goes back in the 401k account and sits there and grows like the rest of your funds.
The second is to roll your funds into an IRA or Roth IRA when you leave your job. A Roth IRA has tax-free withdrawals, and even though you’ll owe taxes on the money you transfer if it was contributed with pre-tax dollars, you can put it in a traditional IRA, convert it to a Roth IRA, and spread your bill over two years.
In short, cashing out a 401k is not really recommended unless you really need the money. Consider the tax implications before you make that decision and try other methods of getting money for your purchase other than removing all your funds from your plan and paying a 10% penalty.