Is it wise to Cashout 401k early?

In the U.S., a 401k is a plan that allows a worker to save and invest savings for retirement while deferring income taxes on the saved money and earnings until withdrawal. In a 401k plan, a portion of the employee’s wages are paid directly into his or her 401k account. This payment or deferment is also called as "contribution".

401k plans are mainly employer sponsored plans, in which the employer can optionally choose to match part or all of the employee’s contribution by depositing additional amounts in the employee’s 401k account or offer a profit sharing contribution to the plan. There are a number of 401k plans to choose from, one of it is the participant-directed plan. In this type of plan, the employee can select from a set of investment options that are usually an assortment of mutual funds that emphasizes money market investments, stocks, bonds, or a mix of these.

A 401k is said to be an excellent investment vehicle because of the fact that it allows a person to save for retirement. However, there are situations that arise where an individual must cash out his 401k to pay other financial responsibilities. This process is relatively straightforward, but serves as a last resort due to the penalties incurred during this transaction.

In a 401k plan, one of the options includes cashing out the 401k and taking a loan from it. When cashing out the 401k, an individual doesn’t take a percentage of it; he or she takes it all. This may seem like a good option for someone who wants to buy a new car and pay for it in full. However, that person may be charged for penalties, which is usually around 10%.

An individual engaged in this plan can not be charged this penalty fee when accessing his or her retirement at the age of 60. Moreover, 401k contributions are tax sheltered at first. However, the person may be taxed when he or she accesses the money for an early withdrawal.

Having the retirement savings in your hand to be used at your disposal may seem like a good idea, but it is important to think for the long-term. Starters lose money due to the 10% penalty; say for example, you withdraw $20k. After the 10% penalty fee, federal and state taxes, you are left with an average total of $16k; needless to say, you no longer have that money for retirement. This could be bad if you don’t have a backup plan in place as you could be homeless or working until you are 70 to make ends meet.

It is also said that not all employers have the option to cash out 401k early. Most even advice against it. One of the cases that opts an employer to cash out early is when they undergo extreme financial problems or terminal medical conditions. Job switching is also another case. If a person switches job, he or she can leave his or her 401k as is and pay management fees or rollover to an IRA or his/her new company’s 401k plan. However, there is also the option to cash out early. For a person who is at his or her 20s, they do not have a lot of money invested, so they don’t have much to lose.