Retirement accounts - Early Distribution
Whether you have a 401(k) account, an IRA account or both, there are times in life when you will come close to cashing them out. If you cash them after you reach the retirement age(59 1/2), this is not an issue. However, if you cash them out before retirement, you will cause immense damage to your retirement planning.
 Cashing out your 401(K)/IRA accounts: Remember, there is a good reason why these accounts are known as retirement accounts. You enjoy a federal and state income tax break on contribution to your retirement accounts. This tax treatment allows you to grow your principal amount as well as earnings tax deferred until you tap your account in retirement. However, these taxes become due instantly if you choose to cash out your retirement account. On top of federal and state income taxes, you're also liable for a 10% penalty for early withdrawal.
 Cashing out your retirement account
This is also known as "Early Distribution". This option puts money in your pocket right away but at a big cost to your long term financial future. First of all you'll pay 10% early withdrawal penalty. Then you'll pay federal taxes, state income taxes, social security taxes and Medicare taxes. On top of everything, final distribution amount will be treated as ordinary income and will be added to your gross income at the end of the year for calculating federal and state income tax. You may also lose the potential value of future earnings. If distribution amount is substantial, it may even put you in a higher tax bracket causing you more financial pain. If you decide to take a cash distribution, keep in mind that you don't have to cash out the entire account balance. You can take a portion in cash and potentially avoid taxes and penalties by rolling the remainder into another qualified retirement plan.
Also, if you're facing certain financial hadships, you may be allowed to withdraw money without penalty and last but not the least, you can always borrow money against your retirement account without paying any taxes or penalties.Here are some simple calculations to show you the full financial impact of an early distribution.
Assumptions:
Total funds in your old Retirement account = $25,000
Your Tax Filing Status = Married filling jointly. Current Federal Tax Bracket = 25%, State income tax = 7%
| Total Retirement Funds |
100% |
$25,000 |
| Early Withdrawal Penalty |
10% |
$2,500 |
| Social Security |
6.2% |
$1,550 |
| Medicare |
1.45% |
$362.50 |
| State Income Tax |
7.00% |
$1,750 |
| Federal Tax |
25% |
$6,250 |
| |
| Total Taxes |
49.65% |
$12,412.50 |
| Net Payout |
50.35% |
$12,587.50 |
It is very clear from the table that you paid almost 50% of your retirement funds in taxes. On top of everything, the net payout of $12,587 can also put you in a higher(for example, a 28% tax bracket) and that will add to your tax liabilities at the end of the year. Bottom line - Even though cash out puts money in your pocket, you lose big time in taxes and chances are that the money you received from cash out will be spent and not saved for retirement.
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