Dear Dr. Don,
At 45 years old, I was recently terminated from my position after working with the company for seven years. My 401(k) balance is only $4,000. I was thinking about cashing out since I am now on unemployment. What are the penalties for cashing out on this amount?
-- Linda Layoff
Presuming contributions to the account were originally tax deferred, cash taken out of the account would be taxed as income along with an additional 10 percent penalty tax on the early distribution. There are exceptions to the penalty tax for early distributions (before age 59 1/2), but you're more likely to qualify for an exception from a distribution out of a rollover individual retirement account than you are in your former employer's 401(k).
According to Internal Revenue Service publication 590, one possibility for an exception involves when "the distributions are not more than the cost of your medical insurance due to a period of unemployment." You might want to talk to a tax professional if you are uncertain whether you might be able to properly avoid the 10 percent penalty which adds to your federal income tax bill.
Even if you decide to keep the money in a tax-advantaged retirement account by opening a rollover individual retirement account, it's common for 401(k) plans to have a provision to allow your former employer to send you a check if you have a balance of less than $5,000.
If your former employer does send you a check, the distribution is subject to 20 percent mandatory withholding. From the date on the check you have a 60-day window to make a tax-free rollover into an IRA.
Good luck finding your next job! Try to keep the money invested for retirement. But if not, pay the tax man and cash out the account and hope for better times ahead.
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