Can You Cash Out Your 401k If You Get Fired?
Accessing your 401k after being fired involves more than just requesting a check. Understand the lasting financial impact before making a move with your savings.
Losing a job creates immediate financial uncertainty. When your employment is terminated, you gain control over the funds in your 401(k) account, presenting you with a significant decision. While the money is accessible, several paths are available for managing these funds, each with its own rules and financial consequences.
Understanding Your 401(k) Options After Termination
After separating from an employer, you have three main choices for your 401(k) assets. The first is to cash out the account by taking a lump-sum distribution of your entire vested balance. This action provides immediate access to cash but comes with significant tax consequences and is often considered a last resort.
A second option is to roll the funds over into another tax-advantaged retirement account, like an Individual Retirement Account (IRA) or a new employer’s 401(k). A direct rollover moves the funds from one plan administrator to another. An indirect rollover involves receiving a check that you must deposit into a new retirement account within 60 days to preserve its tax-deferred status.
The third choice is to leave the funds within your former employer’s 401(k) plan, which is an option if your vested balance is $7,000 or more. For balances between $1,001 and $7,000, your former employer can move your funds into an IRA in your name. For balances of $1,000 or less, the employer may cash out your account and send you a check.
The Financial Implications of Cashing Out
Cashing out your 401(k) triggers immediate financial consequences, starting with a mandatory 20% federal tax withholding. Your former plan administrator withholds this amount for federal income taxes before sending you the money. This is a prepayment, not the final tax bill.
The entire distribution is considered taxable income for the year you receive it, which could push you into a higher tax bracket. When you file your annual tax return, you will calculate the total income tax owed on the distribution. The 20% that was withheld is credited toward that amount, and you may owe more or receive a refund.
On top of regular income tax, if you are younger than 59½, the IRS imposes an additional 10% penalty tax on the early distribution. This penalty is calculated on the total withdrawal amount and is paid when you file your taxes. Some states also levy their own income taxes on retirement distributions.
For example, with a $50,000 401(k) balance for someone under age 59½, the administrator withholds $10,000 (20%) for federal taxes, so you receive a check for $40,000. At tax time, you would also face a $5,000 (10%) early withdrawal penalty. The full $50,000 is added to your taxable income for the year.
Exceptions to the Early Withdrawal Penalty
The IRS provides several exceptions to the 10% early withdrawal penalty for individuals under age 59½. One is the “Rule of 55,” which allows penalty-free withdrawals from the 401(k) of your most recent employer if you leave that job during or after the calendar year you turn 55. These withdrawals are still subject to ordinary income tax.
The Rule of 55 is specific to the 401(k) plan of the employer you just left and does not apply to funds in an IRA or a 401(k) from a previous employer. To use this exception, you must leave the money in that specific 401(k) plan. Rolling it over to an IRA negates the rule’s benefit.
Other exceptions exist for specific circumstances, including:
- Becoming totally and permanently disabled.
- Taking distributions as part of a series of substantially equal periodic payments (SEPP) based on your life expectancy.
- Paying for certain medical expenses that exceed 7.5% of your adjusted gross income.
- Satisfying a court order in a divorce, known as a Qualified Domestic Relations Order (QDRO).
The Process for Requesting a Distribution
To take a cash distribution, you must first contact your 401(k) plan administrator. Their contact information can be found on a recent account statement or through your former employer’s human resources department.
You will need to request the paperwork for a lump-sum distribution. Many plan administrators offer an online portal for this, while others require physical forms. These forms will ask for personal information and your election to receive a full cash distribution.
After completing the forms, you submit them to the plan administrator online or by mail. The administrator will then process the request by selling the investments in your account. The process, from request to payment, typically takes several weeks, and the funds are usually delivered as a check.