My husband is about to leave his job for a new one. He has about $6800 in a 401(k). We were looking at taking it out in a lump sum, to pay off our debt. I know there is a 10% penalty for taking it out

Asked by Chelsey

4 Answers

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Answered by Michael Keeler, CFP®, CLTC in Las Vegas, NV
When you take a distribution from your 401(k) before age 59 1/2, you pay an additional 10% penalty in addition to the income tax on that amount. This could end up to be 30% or more! This means you would get maybe $47,60. Unless you are feeling extra charitable towards Uncle Sam, you are better off keeping it in the 401(k) or rolling it over to an IRA.

My guess is you could work on a budget so you can pay down that debt on your own without giving extra money to Uncle Sam. | 10.14.15 @ 16:50
Comments 2  
Chelsey — Thank you for the response. I did a little more research and found the answer to my real question which I guess didn't post completely. I know about the 10% penalty. We are only taxed at 10% for federal taxes, so the 20% they take is more than enough to cover the taxes we would owe on it. I am not real thrilled with giving uncle sam extra, but we have cut corners everywhere and are still struggling to get ahead. We have been trying to pay down the debt with the snowball effect. I am just trying to pay off two credit cards, to have more than 20 dollars to my name at the end of the month. Also going to use the money to get some much needed work done on our only form of transportation. | 10.14.15 @ 18:26
Michael Keeler, CFP®, CLTC in Las Vegas, NV — If you are struggling that much, I agree that it makes sense. Having transportation is important. If you can get more breathing room by paying down the cards, make it happen. Dave Ramsey's Total Money Makeover is a pretty good program and I have seen it work for many people. Keep working that snowball. | 10.20.15 @ 20:27
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$commenter.renderDisplayableName() — {comment} | 12.08.16 @ 06:24
Answered by Michael Minter, Financial Adviser in Tampa, FL
Chelsey, you are doing the right thing, don't let any of us so-called experts tell you otherwise. Credit cards over time will cost you well more than the penalties and taxes you will be incurring. More importantly, you won't be able to achieve success when you are swimming against the tide, especially as interest rates and who knows tax rates continue to rise. I do suggest reading a good book, it's called I-Plan, very simple read, but there is one important chapter early on that will help you and your husband use this experience as a way to make the necessary changes to get back on track to achieving financial success, which it sounds like you are already doing. All the best & much success. | 10.20.15 @ 19:39
Comment 1  
Chelsey — Thank you I will definitely check it out! | 10.20.15 @ 20:40
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$commenter.renderDisplayableName() — {comment} | 12.08.16 @ 06:24
Thanks for clarifying with your Comment Chelsey. I hate to see families distribute their 401k instead of rolling it over, but sometimes it can make sense. Please read this all the way to the end!

If your credit card interest rate is higher than the 10% tax penalty, then you may come out ahead in the short-term. But, there is a huge long-term cost.

You need reliable transportation to get to work on time so that you can earn a living and replace your 401k balance as quickly as possible.

Don't get an income tax surprise next year! BE SURE TO CHECK your "marginal" income tax rate and make sure that it's really only 10%. People get that confused with their average income tax rate which is the amount of tax they pay divided by their taxable income. Your marginal rate is important because that is what determines the amount of tax on your highest dollar of income (in your case the rate you would pay for your 401k distribution).

You can check your marginal income tax rate here: http://www.irs.com/articles/2015-federal-tax-rates-personal-exemptions-and-standard-deductions .

Depending on how much longer you work, and your investment return, that $6,800 if left in your retirement account could mean as much as $6,800 per year in income at retirement. That's the huge long-term cost.

Track your income and expenses so that you and your husband can make informed decisions about how important it is to continue those behaviors. You may find that you could agree on a change or two that could help you save more toward an adequate cash reserve and retirement. | 10.20.15 @ 19:44
Comment 1  
Chelsey — I appreciate the comments. We have knuckled down as much as possible, we dont' pay for t.v or any extras. We pay basic bills, rent, utilites, car payment, insurance. I budget our family of 4 $200 a month on groceries. I have cut everywhere we possibly can. I have used the IRS calculators to check and recheck our tax rate. I don't want to be caught unawares if we do cash out his 401k. I never would have thought of touching his 401k, until he got his new job and we have the ability to take it out. I am just trying to get above the water a bit, to give ourselves more wiggle room, His new job is a government job and we will be contributing again to his retirement plan. I really dislike the thought of taking out the money, but feel it is better served at this time paying down a few debts. | 10.20.15 @ 20:39
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$commenter.renderDisplayableName() — {comment} | 12.08.16 @ 06:24
Answered by Rudy Ruiz, Financial Adviser in Camarillo, CA
There has been three great answers to your question so I will try not to repeat what you have already read. I'll just take a different approach to your question and hopefully it will be useful for you. It's understandable that sometimes things do not go as planned so making necessary tough decisions is needed. In your case, its taking out the funds from the 401k to pay for transportation and bills. When taking a lump sum out from a 401k, there usually will be a mandatory 20% withholding from the plan plus they may tack on the extra 10% early withdrawal penalty ( i.e. before 59 1/2). Thus, after the mandatory tax and early penalty you will be receiving that much less. However, If I may suggest a method. An individual can request to have the money rolled over to an IRA, which can be opened at a bank ( example IRA money market which is opened from a banker and not the financial advisor). By doing this, now all the money can go into the IRA without and taxes or penalties. Once the funds are inside the IRA money market, it can sit there and wait for you to find the car you want without any fees. Once you make a decision, you can go back to the banker and tell them you wish to withdrawal the funds and that you will pay the taxes and early withdrawal penalty when taxes are due. Thus, you'll receive a 1099 R for the next tax season ( depending on what year the money comes out) and benefit of having all of your money to use. Hope this helps | 10.20.15 @ 22:54
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$commenter.renderDisplayableName() — {comment} | 12.08.16 @ 06:24
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