Tax Tips: Cashing out your 401(k) early
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.