How to Liquidate a 401(k)?

A 401(k) is a great way to save for retirement. The majority of Americans use 401(k)s as their primary retirement savings vehicle. Over time, a 401(k) can amass quite a sum of money from contributions and compounding growth. However, with such a large amount of money saved, some may be tempted to liquidate their 401(k) and enjoy the fruits of their labor.

You can’t withdraw funds from an employer-sponsored 401(k) while you’re still working for that company. But you can liquidate the funds in your 401(k) through early withdrawals, hardship withdrawal, 401(k) loans, and a few other circumstances the IRS permits.

The IRS provides tax breaks for the funds that are contributed to 401(k)s. They also impose penalties should the funds be taken out earlier than allowed.

Nevertheless, it is possible to liquidate a 401(k) and access the funds when you need them.

What are the penalties for withdrawing 401(k) funds early?

The IRS generously allows you to contribute to your 401(k) with pre-tax money. Meaning you can put money into your 401(k) without paying taxes first. You’ll owe taxes on distributions you take during retirement. However, your contributions and growth will be tax-free.

On the other hand, withdraw your money too soon, and the IRS hits you with a 10% penalty tax for any amount you take out. This is on top of the income tax you’ll be required to pay.

In some circumstances, the IRS will waive this 10% penalty if you meet specific criteria. This makes liquidating your 401(k) easier and penalty-free.

You can liquidate your 401(k) after you turn 59½

The IRS considers you eligible for retirement distributions once you’re 59½. At that point, you can access your 401(k) and withdraw your funds as you please.

Again, you’ll still owe income tax on the amount you withdraw. But you won’t incur any penalties or limitations from your 401(k) administrator.

Additionally, you can liquidate your 401(k) if you leave your company during the calendar year you turn 55. In this instance, you can withdraw your 401(k) funds as you would if you were retired with no penalty. This stipulation only applies to the 401(k) you held at the company you left during that year. Any old 401(k)s you still have at previous employers will not be eligible to be withdrawn.

It’s best to find your old 401(k)s and roll them over to an IRA or your current 401(k) before turning 55, so you don’t run into this issue.

You can take early withdrawals

In most cases, early withdrawals from 401(k) will be subject to the IRS’s 10% penalty tax. However, there are a few instances when this penalty is waived.

Rule of 55

As mentioned previously, withdrawals from a 401(k) are allowed if you leave your job during the calendar year you turn 55. For public safety workers, this age restriction is reduced to the calendar the worker turns 50.

Substantially equal periodic payments

Substantially equal periodic payments require you to withdraw a certain amount for at least five years or until you’re 59½—whichever is later. Elect to receive substantially equal periodic payments when you’re 45, and you’ll need to commit to withdrawing from your 401(k) for 14 and half years.

Permanent disability

If you become permanently disabled as defined by your employer’s 401(k) plan, you can liquidate your 401(k) at no penalty.

Qualifying medical expense

Medical expenses that exceed a certain percentage of your adjusted gross income, you can withdraw from your 401(k). This applies to you, your spouse, children, and other dependants.

Qualifying domestic relations order

If required through a divorce or marital separation agreement, you can liquidate a 401(k) to satisfy any requirements.

Qualify for hardship withdrawals

The IRS classifies hardship withdrawals as an expense “Due to an immediate and heavy financial need.” They also limit the withdrawal to the “amount necessary to satisfy that financial need.

Included in the IRS’s list of qualifying hardships that you can liquidate your 401(k) for are:

• Medical expenses
• Costs associated with purchasing your first primary home
• Payments necessary to avoid eviction or foreclosure
• Funeral expenses for parents, spouses, children, or other dependents

Take out a 401(k) loans

If permitted by your employer’s plan, you can liquid a portion of your 401(k) through a loan. Like any loan, there are limitations and requirements to stay compliant with the loan.

The amount you take a loan against your 401(k) is capped at the lesser of 50% of your balance or $50,000 within a 12-month period.

Additionally, you pay back the full amount plus interest per the loan terms set by your 401(k) plan’s administrator. Default on the loan and it will be treated as an unqualifying distribution and be subject to income tax and a 10% penalty tax.

Consider alternatives

Before liquidating your 401(k), it’s essential to consider other options to obtain the funds you need. Taking money out of any retirement account will cost you not only penalties and tax but shrink the amount of compounding interest your retirement account will see.

Although not ideal alternatives, taking out a personal loan through a local bank or credit union can help you without liquidating your precious 401(k) funds. Additionally, if you have a plan to repay the funds quickly, perhaps a zero-interest credit card for 12-18 months may get you access to the money you need.

The important thing to remember is you should leave the money you’re saving for retirement to grow, so it’s there when you retire. If you liquidate your 401(k) early, you’ll be putting your future self at risk and perhaps limiting your retirement.