Tax Tips: Cashing out your 401(k) early

One of the biggest money mistakes you can make is taking money out of your 401(k) or other retirement account early. This mistake can cost you a huge amount of money at tax time, and most taxpayers aren't ready for it. When you leave a job, you have the option of cashing out your retirement account, rolling it into another retirement account, or leaving it where it is. The best option is to roll it into an IRA that you control. Each time you leave a job, you can roll all the funds into this one account, avoiding tax consequences and consolidating control over your money.

The worst option is cashing out the retirement account. And cashing out a retirement account should also be considered a last resort in other situations when you need money fast. Some retirement plans have exceptions built into them, which allow you to cash out money for certain emergencies (like avoiding foreclosure, paying certain medical bills, or other catastrophic situations). Under these exceptions, you'll still have to pay regular income tax on the money you cash out, but usually you don't have to pay tax penalties.

But if you cash out a retirement account early and don't fall under one of the exceptions, the taxes and penalties mount quickly. A good rule of thumb is to expect to lose about half of your money to taxes and penalties at the federal and state levels. Most times, when you cash out, only 10% of the money is withheld and sent to the government toward your tax bill. You'll still owe the other 40% at tax time, and if you're like most consumers, you'll probably have spent the money by then. If you need cash, try to find another way that doesn't cost you so much.

Tracy L. Coenen, CPA, MBA, CFE performs fraud examinations and financial investigations for her company Sequence Inc. Forensic Accounting, and is the author of Essentials of Corporate Fraud.