A 401(k) plan is a retirement program that incentivizes you to save part of your pre-tax earnings and gives your employer a means to contribute to your retirement. A 401(k) essentially has taken the place of a pension plan for many American workers, which is why rules and regulations penalize you for taking it out early.
You cannot cash out your 401(k) until you turn 59 1/2 without paying a significant penalty, with a few limited exceptions. Certainly, if you die, your money may be distributed to your heirs or estate. If you become disabled, you may apply to tap into your investment. A hardship, as defined by the Internal Revenue Service, also can open your account to penalty-free distribution. Hardship needs can include educational purposes, medical bills, down payment for a house, housing repair, money to avoid eviction and funeral expenses. If you leave your job, your company has the option to cash out your 401(k) and send you the balance, minus 20 percent for taxes. If you don't roll the funds over to another eligible retirement fund within 60 days, you could incur penalties.
The standard federal tax penalty for withdrawal from 401(k) plans before you turn 59 1/2 is 10 percent. You report that information on IRS Form 5329, which then is reported on your annual 1040 tax return. The 10 percent penalty is on top of the regular tax you will pay, as the distribution is considered additional income. Your employer is required to take out 20 percent up front to pay your taxes, leaving you with less of a windfall than expected. There is no additional penalty to report on your state taxes with the exception of California, which places a 2.5 percent penalty on early 401(k) withdrawals.
Many 401(k) plans have a loan option you can use when you need emergency funds. If your plan includes this option, in most cases, you can take a loan for up to 50 percent of your vested balance in the 401(k), up to $50,000. You must pay back the loan in regular installments within five years. Interest is paid on the loan, typically close to 1 or 2 percent, which goes into your account.
Administration, maintenance and origination fees may be assessed when you take out a loan. The 10 percent penalty fee will kick in on the entire distribution you took if the loan is not repaid within the specified period of time. It’s also possible that the entire loan may be called in if you leave your job, and the remaining balance will be treated as a distribution if you can't repay it. In addition, you aren’t earning the interest on your retirement investment, while you are paying back the loan.