401k Withdrawal Options – Hot Topic for 2009

Call it a sign of the times. The number of Google searches for such phrases as 401k withdrawal options has risen steadily over the last few weeks. As the economy continues to drag, and the unemployment rate continues to rise, more and more Americans are tapping their 401k for additional cash flow.

But what happens with you make an early withdrawal from your 401k plan? What kind of penalties might you face? What options do you have? These are the questions I’ll address with this article.

First, a disclaimer. I am not advising you to make 401k withdrawals, nor am I telling you to avoid it. This is a decision you must make on your own, and it’s the subject of another article entirely. Instead, I will focus on the withdrawal process itself, the options you have, the possible penalties you might face.

Withdrawal Options and Consequences

As a 401k holder, you have several options for making withdrawals from the account. But it’s important to understand each of these options because some of them have more dire consequences, as far as taxes go. Many people choose a lump-sum payment when tapping their 401k, but you stand to incur a lot of taxes when you use this option for withdrawal.

Before we go any further, let’s talk about the various ways you can withdraw money from your 401k. It’s important to realize that these options vary from one plan to another, and from one employer to another. So this entire list of options might not be available to you. At any rate, here are the most common methods of withdrawing money from a 401k plan:

• leaving the money alone (no withdrawal)
• withdrawing cash in a lump sum (mentioned above)
• rolling over a lump sum into an IRA
• converting funds into an annuity
• withdrawing funds in installments

Of course, you could also use some combination of the withdrawal options above when tapping your 401k account.

Which Option is Right for Me?

So which path is right for you? Well, this will depend on a number of factors that I cannot answer for you. You’ll have to consider your age, your income status, your level of debt, and other aspects of your overall financial picture. So let’s talk about the various pros and cons of each 401k withdrawal option, so you can continue your research in a more targeted manner.

For the purposes of this article, we can skip the first option presented above. After all, if everyone could afford to leave their 401k alone, I wouldn’t be writing this article. And regardless of what the economy does, you’ll have to start withdrawing money from the account sooner or later. If you pass age 70 and haven’t started withdrawing money yet, you could incur tax penalties from the IRS.

In this article, I’ll focus on the two options above that are true withdrawals — the lump-sum payment and the installment payments:

Pros and Cons of Lump-Sum Payment

We have briefly talked about the second option already, which is to withdraw money from your 401k as a lump-sum payment. The first and most obvious benefit of this option is that you have instant (and maximum) liquidity. You can cash out the bulk of your 401k savings, minus any fees, and put it to use however you wish. Given the state of the economy, this has become something of a rising trend lately.

The downside to the lump-sum payment comes in the form of taxes. You saw that coming, didn’t you? First, you’ll have to pay income tax on whatever you withdraw from the account. In fact, your employer is required 20% for that purpose. If you’re less than 59 and a half at the time of withdrawal, you may have to pay an additional 10% in taxes for early withdrawal penalty. This can quickly add up to 30% of your 401k amount, which is why you need to think twice about the lump-sum payment option for withdrawal.

Pros and Cons of Installment Payments

You would need to check with your employer or 401k manager to find out if this withdrawal option is available to you. With this method, you would withdraw the value of your account in monthly amounts, usually spread out over five, ten or fifteen years. This option provides a steady stream of income in the form of installment payments, but it limits your options for the very same reason.

Combining More Than One Approach

Keep in mind that  you can also combine two or more of the 401k withdrawal options listed above. For example, you could roll a portion of it into an IRA while withdrawing a lump-sum payment at the same time. However, this is usually more complex than using one option alone. So if you want to take the “mix and match” approach, I encourage you to seek help from a financial adviser who specializes in this area.

Related Resources

This is just a basic overview of the ways you can tap your 401k for cash flow. But as important as this subject is, you should continue your research beyond this website. Here are some websites I recommend that offer excellent information on 401k management:

• Kiplinger.com
• Morningstar.com
• Fool.com
• Smartmoney.com
• 401k.com

I hope you have found this article helpful, and I wish you well in your financial future.