Can I Cash Out My 401K?

I help take care of several 401k plans and after 2008 came along, this question came up a lot from callers to my office.

I start by trying to put myself in the shoes of the caller, trying to understand their motivation for wanting to cash out.  Most are under 59 1/2 which means they will be penalized 10% for early withdrawal.  10% doesn't really mean anything to the person hearing that.  It just doesn't.  It has no real impact.  And if they haven't paid taxes on the deferrals, the cash out will count as taxable income for that year.  The big thing is the mandatory 20% withholding that gets taken out before they even get the check.  Then what happens if they don't have some extra money saved by tax time to cover any increase in taxes owed due to this windfall of income?  That's just one more thing they might not have considered when thinking about cashing out.

So when they do get their check and that big balance is reduced by potentially $1000s of hard dollars, suddenly those ethereal percentages have meaning. 

Not only that, but it is hard for people, particularly young people, to envision a day when they are no longer 28, don't want to or no longer can work.  That money that was cashed out so easily could have grown exponentially over time to provide some future relief and security.  That measly $10 grand could grow to $110,000 over the next 40 years, when that 28 year old was now 68, without even adding a dime, at a rate of return of 6%.

Oftentimes people forget how long it took to get that measly $10 grand saved up in the first place.  But it sure is easy to cash out.

So I try to advise people to really consider these lesser known points when deciding to cash out.  It's almost never in your best interest.