Pacific United Planning, Inc. | Valid reasons to cash out on your 401(k)
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17 Oct Valid reasons to cash out on your 401(k)

Man working on laptopMaybe you’ve changed jobs and forgotten about that 401(k) along with the names of your old coworkers’ kids. Or maybe you haven’t quite forgotten about it, but you thought it was best not to touch it. But life happens, right? As much as we’d all like to save money for the golden years and retire like royalty, as the one and only Mick Jagger put it, “You can’t always get what you want.”

I’m going to go into reasons why you may not want to touch the money in your 401(k). And then I’ll talk about reasons that may justify it. You’ll notice I don’t mention a dream vacation to the Northern Lights, even if you love adventures and dream of going there as much as I do. Life is short, but there are other means to get to northern Europe. But we can talk about that later over a cup of coffee (which by the way I hear is incredible in that region).

Dream vacations aside, I always prefer to hear the bad news first and end on a high note. So, let’s go into the reasons why you may not want to touch that 401(k). Drumroll, please . . .

(By the way, this is meant to be a general overview, but let’s face it: this stuff is confusing. I don’t cover every single tax law, so I urge you to consult a tax professional before you make any big decision.)

The Not-so-good: Reasons why you shouldn’t cash in on your 401(k)

Finger with sharpie drawing of a person

1. All withdrawals from a 401(k) are taxed as ordinary income, based on your tax bracket. If you make $100,000 per year from your job and you cash out the 401(k) worth $50,000 from your old employer, you will now be taxed on $150,000 instead of $100,000. Depending on your situation, this additional income may or may not put you in a higher tax bracket.

2. You will have to pay a 10% early withdrawal penalty to the IRS if you’re under 59.5 years old. This is in addition to the taxes that you owe on the withdrawal.

3. You will have to pay a mandatory 20% federal tax withholding if you take from a 401(k), whether you owe that much or not. If you overpay, you will receive a refund after you file your taxes at the end of the tax year. I’ve met a lot of people who confuse the 401(k) with Traditional IRAs. In Traditional IRAs, we can choose if we want to withhold taxes and the amount we want to withhold. We don’t get a choice if we cash out a 401(k). It’s 20% no matter what.

4. Your retirement will take a hit and it will become harder and harder to make up a savings deficit as you get older because essentially, you’ll have less time. Here are a few scenarios to give you an idea:

Scenario 1: If you’ve saved $50,000 by the time you’re 40 years old and you’re looking to retire at 65, assuming contributions of $881.07 per month and an interest rate of 7%, you will have amassed $1mm by the time you retire.

Scenario 2: If you cash out your 401(k) and don’t start saving until you’re 45, you will need to save $1,919.66/month in order for your account balance to be at $1mm by the time you’re 65.

Scenario 3: If you start with nothing at age 45 and contribute the same as you did before ($881.07/month), your account balance is projected to be $458,973 at age 65. This is a difference of $541,027 . . . all because you cashed out $50,000 and missed 5 years of contributions and compounded interest! Now if you cashed out the $50,000 at 40 but continued to save $881.07/month, your projected account balance at 65 is $713,730. This is still a difference of $286,270!

Do you need that cup of coffee yet? Stick with me. Now we’re getting to reasons that would warrant you cashing in on that 401(k).

Money at your disposal!! Not bad for a first pro, right? OK I know, it’s more complicated than that. I just wanted your eyes to light up for a brief moment.

 

Reasons why you may want to cash in on your 401(k)

Lady shrugging her sholders

Reason #1: You need to pay off or pay down debt that’s crippling you financially.

Medical Debt

And back to reality we go! Medical debt is no joke. Did you know one million medical bankruptcies are filed a year in our country? But we’re not here to talk about why. Let’s talk about how to avoid that situation.

Disability

I know a dentist who spends $3,000 a month on disability insurance. His, neck, arms, wrists, and hands are so important that if something were to happen to them, he’d have to close his practice and say goodbye to his patients of 30+ years. That’s a lot of money to pay every month for a big what-if, but he’d be taken care of should something ever happen.

If you’re like most of us, you don’t plan for accidents that would leave you disabled. (And have you ever thought about how much your wrists are worth? OK, I digress.) The point is, disability insurance probably isn’t even on your radar, is it? But that doesn’t mean we can’t become disabled. What if something were to happen to you that prevented you from doing your job?

Yep. You could cash in on that 401(k) to get you by. Let’s go to the nuts and bolts, shall we?

If you’re disabled, you may qualify for an exemption to the 10% IRS early withdrawal penalty. OK, one piece of good news! In the event of a disability, that’s one con of cashing in on your retirement that may not apply to you. But you know that the IRS has this condition laid out in very specific terms. You wouldn’t expect anything less from Uncle Sam, would you? According to the IRS, “…an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof . . ..” You need a signed statement from your physician as proof.

If you’re like most of the population and don’t have disability insurance, or if it’s not enough to pay the monthly bills, this can go a long way towards getting you back on your feet.

You are still responsible for paying taxes on it though. (Go back to the Not-so-good section above for more on this.)

Other Medical Debt

Thankfully, not all trips to the hospital have to end in lifelong disabilities. But these days, they do tend to end up in astronomical medical bills.

I read a story about a woman who got stung by a bee and wound up with a $12,000 bill for her trip to the emergency room. A bee sting. $12,000. Ouch on so many levels. And if you’re grappling with something more than a bee sting and strict insurance policies, you could be facing thousands more in debt.

If you ever find yourself in this situation, you will not have to pay the 10% IRS early withdrawal penalty as long as your unreimbursed medical expenses exceed 10% of your adjusted gross income. I truly hope you don’t get to this point, but if you do, this may help you avoid having to declare bankruptcy.

Credit Card or Personal Loan Debt

Credit card changing hands

So maybe you have credit card debt because of medical bills. Or maybe because you took that dream vacation to see the Northern Lights. (Sigh.) I have some European friends who will take out loans every year to take a month-long vacation somewhere. (Let’s not even talk about how Europeans get a minimum of 25 days of vacation every year, nor how most Americans don’t even use up their even fewer vacation days.)

Whatever the reason may be, if you have high interest credit card or personal loan debt, cashing out on your 401(k) may be a good idea.

Average credit card interest rates are between 13-15%. If you fail to make on-time payments, the average interest rate jumps to 27-29%! You don’t have to be a finance expert to see that paying off that kind of debt will take a long time and a ridiculous amount of money. I’ve described one scenario in case you’re like me and like examples to better understand things:

Scenario: Let’s say you have a balance of $5,000 and an interest rate of 15%. According to the Bankrate calculator, if you make minimum payments of $100/month (or 2% of the balance), it will take you 27.5 years to pay it all off. In the end, you would have spent a total of $12,517.52 to pay off $5,000 of debt! In this scenario, it probably would’ve been a good idea to pay the penalties and taxes of cashing in on your 401(k) to use it to pay off your credit card balance. Any extra can be used to build up your emergency fund so hopefully you don’t go back into credit card debt in the future.

And in case you were wondering, the average credit card debt in 2018 is $5,700. If you’re not sure whether your debt merits cashing in on your 401(k), speak with a professional and learn how to save money while paying off credit card debt here.

Also keep in mind that your credit score affects your interest rates. You can learn ways to improve your credit score for the future so you don’t fall victim to the bank and ridiculous interest rates. We know the house always wins, but they don’t have to win THAT much.

Reason #2: You may be in a lower tax bracket right now.

Since none of the money in a 401(k) has been taxed, you will have to pay taxes whenever you withdraw the money. None of us has a crystal ball, but if you think taxes will be higher by the time you retire AND there’s a justifiable reason to pull out that money, then you might potentially save a little bit in taxes.

Scenario: Let’s say you were making $120,000/year before taxes and you were putting away 10% of your paycheck to the 401(k), so $12,000/year. To simplify things, we’ll assume that there are no other deductions, exemptions, or credits. In this scenario, you will have to pay taxes on $108,000. Based on the 2018 tax brackets, you would be in the 24% federal tax bracket. Got it?

OK, now things get a little gloomy. There are cutbacks at the company, etc. and you are laid off at the beginning of the year. You’ve received one paycheck of $10,000 (before taxes) and contributed $1,000 to your 401(k) so far in the year. Assuming you didn’t work for the rest of the year, you will have to pay taxes on $9,000 which equates to the 10% federal tax bracket. Since all 401(k) withdrawals are taxed, everything you pull out will be added to your income for the year. The 24% tax bracket in 2018 maxes out at $157,500. If you want to remain in the 24% tax bracket, you can potentially pull out $148,500 ($157,500 – $9,000). If you want to pay taxes at 22%, which maxes out at $82,500, you can potentially pull out $73,500. Of course, things are never super straight-forward, especially when we’re dealing with the IRS, so make sure you consult a tax professional.

And remember, if you’re under 59.5 years old, you may have to pay an additional 10% IRS early withdrawal penalty. (There are some exemptions, so again I urge you to consult a professional.)

Reason #3: You don’t have a job and need to pay the bills.

Man sitting on couch with head in hand

Yay! Life doesn’t care that you’re unemployed and you get to pay your bills! (Please note the sarcasm oozing through my fingers as I type this.) Obviously, this will give you instant cash to pay your monthly bills and hopefully, it will last until you find your next job.

You will ideally have an emergency fund consisting of 6 to 12 months of living expenses. If you don’t have any liquid assets and can’t or don’t want to borrow money from family/friends (this can be awkward and lead to more problems you don’t need), then this is pretty much a necessity. This is a great example of why saving towards an emergency fund should always be a top priority.

In Conclusion . . .

Let me be clear that I’m not trying to convince you to cash in on your 401(k). My goal is to inform you, share some experiences, and help all of us make better, more informed decisions. Things are never black and white. (In fact, the Northern Lights are blue, green, yellow, pink . . . my apologies, again I digress.)

Explore all your options and consult a tax professional who knows your complete financial situation. I hope this has helped you evaluate your options and if you ever want to discuss any of this over a cup of coffee, I’m an email or phone call away.

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David Yu, CFP®
dyu@pacunited.com

David Yu is a CERTIFIED FINANCIAL PLANNER™ practitioner with over 10 years of industry experience helping people make smart, lasting financial decisions. He believes in developing strong, lasting relationships based on mutual trust and honesty. He also provides helpful resources via his blog, THE INQUISITIVE MIND. In his spare time, he enjoys traveling, Brazilian Jiu-Jitsu, tennis, and USC football.