Talk me through closing a 401k
September 27, 2012 2:35 PM   Subscribe

I have lost my job, and I want to use some of the money in my 401k to pay my bills, but not all of it. I would like some details about the next steps, if you have experience with this.

I have about $25,000 in a 401k. I owe about $6000 on a pretty high-interest loan and a credit card. Because I am not sure how long it will be until I have another job, I would really like to pay this $6000 off, rather than continue to pay the monthly bill while I have no income.

I also have a $3000 loan that I took from my 401k, and I know I will need to pay it back because I have lost my job.

I still want to earn interest on the money that I don't need to pay off the bills. So, the way I see it, I would like to take about $10,000 from my 401k ($6000 to pay the first loan and credit card, $3000 to pay the 401k loan, and $1000 just to have for emergencies). I would like to keep the remaining $15000 in some kind of retirement savings plan to earn interest.

I really have no idea how any of this works, and I would love step-by-step information and advice on how to get the most out of my money.

I am aware that I will have to pay taxes on the money I withdraw (20%, I think, which is lower than the interest on the loan/credit card, so I feel okay about it). I also hear that I will have to pay a 10% penalty to the 401k company (Fidelity).

I am wondering if I keep the remaining $15,000 with Fidelity, do they wave the penalty? Can I even have a 401k if I am not employed and not contributing to it?

Also, can I use the money I withdraw to pay the $3000 loan I have with Fidelity?

I'm confused, and I want to make sure I handle this well.

Thanks for the help.
posted by anonymous to Work & Money (20 answers total) 4 users marked this as a favorite
You pay the taxes and penalty only on the part you take out.

20% Federal tax. 9% State tax if you're in Calif, or whatever your state taxes, if anything. Plus 10% penalty (goes to the Feds, too, not Fidelity). That's nearly 50% of your withdrawal going down a hole.

Taking $10,000 out would probably leave you only about $6000 in there. This is a VERY expensive way to pay back a credit card and pay your bills.

Yes, you can use the money you withdraw to pay back Fidelity, but if I'm understanding correctly, you'd be paying a ton of taxes on something that you'll have to pay taxes on again when you pull it out.

If there is anyway NOT to do this, I recommend it. Any handy rich relatives? You've already applied for unemployment, right?
posted by small_ruminant at 2:42 PM on September 27, 2012 [1 favorite]

Also, your company might force you to take all of your money out. It's in their legal and financial interests to do so. If so, you should roll it into an IRA directly.

The way you do this is to open an IRA someplace, get the new account number, and then go to Fidelity and fill out their 401k distribution form. There will be spot on it for your IRA's account number and firm address. Once the forms filled out (and you might have to have HR sign it to confirm you're not working there anymore) and submitted, Fidelity will mail your money/assets to the new account.

You can open your new account at Fidelity, too, if you like them. You can open it anyplace.
posted by small_ruminant at 2:45 PM on September 27, 2012 [1 favorite]

Seconding small_ruminant: they REALLY punish you for taking out money early. The ONLY way to kinda-sorta get around this is to, 1. Roll that 401(k) over into a new retirement account that is, 2. Administered by a company who permits hardship withdrawals and/or loans, and then to, 3. Take one of those.

One thing you MIGHT consider - I am no tax expert, but it occurs to me that if you wait until January to make a withdrawal, you MAYBE would be taxed at a lower rate (on account on you'd be in a lower income tax bracket, on account of you'd HAVE no income)? But I dunno, perhaps they'd still tax you at the rate you were at when you earned it.
posted by julthumbscrew at 2:46 PM on September 27, 2012

I don't think rolling it into another 401k account is an option unless the OP gets a new job that allows it, and I'm pretty sure the OP would have to pay back the loan before it rolled anyplace. I also don't know of IRAs that allow hardship withdrawals.
posted by small_ruminant at 2:58 PM on September 27, 2012

Don't prematurely end the 401K. You've already borrowed 3K from it, why not borrow some more and at least pay off the high-interest loan? Typically you can borrow half the amount, so you could get 9K more from it, low interest, the interest goes to you, and the collateral is the 401K itself, so you won't be turned down just because you don't have a job.
posted by ubiquity at 3:06 PM on September 27, 2012

Ubiquity, are you saying to go to a bank and ask for a loan, using the 401k as collateral?
posted by small_ruminant at 3:08 PM on September 27, 2012

No. Some 401K plans allow you to borrow against them. Since the OP said "I also have a $3000 loan that I took from my 401k" I assumed his plan allows this.
posted by ubiquity at 3:27 PM on September 27, 2012

Worth an ask, but generally when you don't work at a place anymore, you don't get to take out loans. In fact, usually you have to pay back all your old ones.
posted by small_ruminant at 3:33 PM on September 27, 2012

ubiquity: Most 401k plans only allow borrowing while you're working for the employer, and the loan is due immediately, in full, if the employment is terminated for any reason.

I'm not very money savvy, but you may be better off paying the high interest credit cards off slowly than withdrawing from 401k to pay them off (if you won't default).
posted by ethidda at 3:36 PM on September 27, 2012

Oops, sorry, I didn't know that. I borrowed from my plan many times but I was never terminated while a loan was outstanding.
posted by ubiquity at 3:42 PM on September 27, 2012

Roll the entire 401k into an IRA, then take what you must out of the IRA and pay the penalties.
posted by alms at 3:43 PM on September 27, 2012

You don't have to pay back the $3k loan if you don't want to. If you don't, it just gets counted as a $3k early withdrawl, subject to taxes and penalties. You didn't borrow the money from a bank, you borrowed it from yourself.
posted by hwyengr at 4:01 PM on September 27, 2012

First, roll the 401(k) over to an individual IRA, then you can do whatever you want with it. I like Fidelity, they are super-easy to deal with and will answer questions forever. Call them, they'll send you the paperwork, you fill it out and send it back to them. Easy-peasy.

If you do decide to take a premature withdrawl, prepared to be shocked. Your brokerage will be happy to withhold for federal and state taxes, but it won't be enough, I had a total of 25% withheld and I was WAY off. I'm still paying mine off. Two years later.

If you have ANY options at all, don't be an idiot like I was. Don't do this!
posted by Ruthless Bunny at 5:01 PM on September 27, 2012

Talk to a financial advisor and/or CPA...many of them will do a free consultation and be able to lay out the pros and cons of various strategies for your situation. And just because you met with them doesn't mean you don't have to sign any new contracts. Rolling the 401k into an IRA is definitely the best starting place, and chances are high they could recommend companies with low(er) penalties than Fidelity's.
posted by csox at 6:20 PM on September 27, 2012

Ignore this last. The cost of withdrawing the money, tax on the amount plus the 10% penalty, is mandated by Federal law. It is uniform among all custodians.
posted by megatherium at 7:22 PM on September 27, 2012

I've done this. That 10% is a bit painful, but it got me out of an annoying financial bind so the reduced stress was well worth it IMHO. Of course, I only withdrew like 10% of my total value and I was still pretty young so I had time to make up for it.

The one tip - Fidelity (or whoever) doesn't withdraw the 10% penalty and time of payout (Unless something's changed and now they do). You have to remember to include that with your taxes come next April. I was misled by something the guy told me and ended up getting a bill from Uncle Sam a few years later. (I told the IRS, "My bad!", wrote them a check, and they charged me a smaller late payment fee for being two years late than my bank does if my credit card payment is two days late.)

I you have anything in a Roth IRA or 401K, you can always withdraw the principal without penalty since you've already paid the taxes on it. (Kid Charlemagne is not a financial adviser and secretly suspects there are subtle complexities beyond this, but this is what he's been told.)
posted by Kid Charlemagne at 7:54 PM on September 27, 2012

I am completely not a Roth expert, but as I understand it, if you're talking about a regular Roth, you can take out your contributions but not earnings without penalty. If it's a Roth you converted from an IRA you have to wait 5 years and then there are stipulations, like it has to be their $10k max for a first time home, or medical expenses.

I thought about this, because I was thinking the OP could at least get out of the penalty if s/he first rolled the 401k into a Roth IRA and paid the taxes, but the more I thought about it, the more I realized that strategy wouldn't work.
posted by small_ruminant at 8:31 PM on September 27, 2012

I am wondering if I keep the remaining $15,000 with Fidelity, do they wave the penalty? Can I even have a 401k if I am not employed and not contributing to it?

- Fidelity cannot waive the penalty, it's a requirement of being a 401k account
- It is very unlikely that you will be forced to close the account - the minimums required to keep a 401k open are about $1000-$5000, which you should be comfortable over even after your withdrawal, but call your plan administrator to confirm this. (There should be a contact number listed on the documents you have enrolling you/your statements from the account. These people can probably give you good overall advice as well.)

1. you need real financial advice. If you belong to a credit union or maybe even a bank, they should have a financial advisor you can have a free consultation with. Fidelity itself can answer many of your questions - in their online help, or your plan phone number mentioned above.

Also, can I use the money I withdraw to pay the $3000 loan I have with Fidelity?
2. You do not need to take money out of your 401k to pay back the loan from your 401k. If you do not pay back the loan within 60 days of losing your job, it is automatically considered a withdrawal instead of a loan, and the 10% penalty and regular income taxes will be assessed (although note Kid Charlemagne's warning that you may have to organise paying them yourself - besides getting financial advice now when taking the distribution, it might be worth paying someone to check your taxes next April on this one).

3. I think when you say '20% taxes' you are referring to the fact that it will be taxed as income. Depending on your income, it could be less than 20%. You should, as mentioned above, consider whether you will be in a lower tax bracket next year (the tax rate depends on when you make the withdrawal, not when you earned it).

4. I think that rolling it into a Roth IRA right now would be a bad choice, because you don't have spare cash to pay the taxes incurred on the whole thing. Rolling it into an IRA might allow you to use the penalty-free withdrawal for paying for health insurance while unemployed, but only after you've been unemployed for 12 weeks. Before rolling it into any new type of account you absolutely should be sitting down with a financial advisor and checking on what would happen to the outstanding loan balance, and what the difference would be for making withdrawals in the current and new account types.

5. Assuming you leave it in the current 401k account: When you take out $6000 to pay the credit card, it will cost you about $2000 in penalty and taxes, and you'll also owe about $1000 in penalty and taxes on the loan you didn't pay back. You can either hope you have that money by April, or you can withdraw extra from the 401k (or you can ask Fidelity if they can automatically withhold, but get someone else to check the amount they withhold). If you need to cover it all with extra withdrawals, then you should withdraw $10,000. $6000 goes on the credit card, and $4000 goes in a savings account for your tax payment in April. (You see why people are saying this is a last resort type of thing.)
posted by jacalata at 10:54 PM on September 27, 2012

The 10% penalty is a penalty the IRS charges for early withdrawal of your TAX DEFERRED money. THEN you get to pay whatever it is that your Tax Rate is. ALSO, if you take out $10,000, then that adds $10,000 to your total Income, so not only are you taxed at a higher rate on your 401(k) withdrawl, you are also taxed at a higher rate on ALL of your income that year.

Good Times.
posted by Ruthless Bunny at 6:42 AM on September 28, 2012

Another tax angle to consider, which is not related to the 401k but might alter your decision. When you filled out your W4 at work, your employer began to withhold taxes in accordance with your dependents and such and also based on the amount of money they expected you to earn this year by working the full year. Let's say you earned 3/4 of what you and company expected to earn this year in terms of employment income; your reduced earnings probably qualify you to pay a lot less in taxes than you've paid. While the amount of withholding scales linearly with your earnings, your taxes scale up according to the tax-bracket system, where only your topmost dollars are taxed at the highest rate. In other words, if you were expecting a return next year, I believe you can anticipate a larger return.

That said, I think (don't bank on this) that withdrawing from your 401k will count as income in such a way that it'll by taxed at the highest rate (or higher, in the unlikely event it carries you into a new bracket-- very unlikely, I would say, at least among the class of people who get tax advice from the crowd, a statement I offer with no disrespect).

Unemployment, should you collect it, will throw you back into the earnings category, and hopefully they'll withhold money as well (if they offer, I recommend you take them up on it-- otherwise, try ot reserve some of the money, as now you've got to do your own withholding). You'll pay income taxes on that on top of your prior earnings this year, but there's no W4 in play.

I'm not trying to complicate things, and that tax return is at least 4.5 months away if your company waits until Jan 31 to send your W2. But you may have a future windfall with which to pay these debts.

Best of luck to you.
posted by Sunburnt at 3:43 PM on September 28, 2012

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