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The Hazards of Cashing Out Your 401(k) and How to Safeguard Your Savings

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When departing from a job, the instinct to transfer your 401(k) funds can be powerful. After all, it’s your hard-earned money, and leaving it behind could lead to unpleasant outcomes. High fees may hinder your savings growth, or worse, you might totally forget about the account.

On the surface, cashing out the account and moving the funds elsewhere may seem like the simplest solution. However, this approach comes with a significant drawback. Here’s what you should be aware of when dealing with your 401(k) assets.

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The Pitfalls of Cashing Out Your 401(k)

Withdrawing cash from your 401(k) account is viewed by the government as a distribution, making it subject to taxation. Additionally, if you are below 59 1/2 years of age, you will likely face a 10% early withdrawal penalty.

To circumvent these taxes and penalties, you can perform an indirect rollover by depositing the withdrawn amount into a new IRA or 401(k) within 60 days. Yet, there’s a catch to this process.

When cashing out your old 401(k), the plan administrator automatically withholds 20% of your balance for tax purposes. To avoid taxes and penalties, you must transfer the full balance of your old 401(k) to your new account, necessitating additional funds to cover the withholding and complete the indirect rollover.

If you successfully execute it, you will receive the withheld amount from the plan administrator during tax season. Fail to transfer an amount equal to your old 401(k) balance, and the government will treat the shortfall as a distribution.

Safeguarding Your 401(k) Funds During Transfer

To avoid the tax burdens and penalties linked with indirect rollovers, opt for a direct rollover. In this scenario, instruct your old 401(k) plan administrator on where to send your funds, and they will handle the transfer for you, albeit potentially charging a one-time fee.

If you lack an existing IRA or new 401(k) for the fund transfer, establish one beforehand. When intending to move your money to your new employer’s 401(k), ensure it permits transfers from another 401(k) plan. Contact your former plan administrator for guidance on the next steps. Inquire about the transfer duration and verify the successful deposit of funds into your new account.

Once your funds are in the new account, you must decide on investment strategies. Although this process is not time-consuming, the benefits are substantial. Your savings will continue to grow, and you’ll streamline your account management, minimizing the risk of overlooking your finances.

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Opinions shared by the author in this piece are personal and do not necessarily mirror the views of Nasdaq, Inc.

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