401K Taxes & Early Withdrawal
Financial literally is important and as a personal finance blogger I sometimes take my knowledge for granted. This particular story happened to a former schoolmate of mine. She received what she thought was a “blessing” check. I would like to hide her identity so let’s call her Mandy. Any way, Mandy accidentally cashed out her family’s 401K check for a house down payment. This is her cautionary tale.
Mandy’s Story –
Debt & Life Happens
Mandy and her husband have been dreaming about purchasing their first home for years. She is a stay-at-home mom and her husband is a fiberglass installer at a local engineering/contracting firm. They are 25 and 29 years old respectively. Her husband makes a healthy salary of around $68K a year and cost of living in their small Northern California town is around the American national average.
Mandy and her husband are what I think of as the average American middle class. They have two cars, two degrees and too high of a credit card balance. They were almost $70K in debt; mostly from a car loan ($25K) and both of their student loans ($40K total). Mandy and her husband lived comfortably at her mom’s 2 bedroom house in the suburbs. It was all in an effort to save up money someday for a home. After having a set of fraternal twins last year, Mandy found herself and her own growing family running out of space at her mother’s house.
Now tack on another $30K as life has proven time and time again: babies are expensive.
Their debt almost hit 6-figures! It was not until that point did they realize hoarding so much debt was a bad start for their children. Mandy was mostly worried about something happening to her husband. She said to our group chat via messenger, “it’s hard to picture what would happen to us if my husband didn’t come home one night (half kidding). Me and the kids would be in financial ruin.”
Babies give awesome wake-up calls.
They started tackling their debt quite ferociously using the debt snowball method and made good progress on their bills. Their debt was down to $70K again in just a few months! I was so impressed. It’s always absolutely incredible to see how some hustling (Mandy started baby-sitting on the side) and concentrating on staying under budget (only paying with cash) can transform the basic foundation of so many people’s lives.
Charged with the rapidly forthcoming possibility of being debt free they were side swiped by a great housing opportunity that came up in the neighborhood. The house for sale was not too far from Mandy’s mom which was exactly what they wanted. The house itself sits on a corner lot and had a sizable yard with a small water feature that’s uncommon to the region. The sellers were on good terms with Mandy’s mother. In fact, the sellers agreed to fix up some minor issues even before the official inspection.
The house was from the 1930s and never went through a single remodel of any kind. I saw photos of the kitchen and I could not tell it was a kitchen. I thought the stove was like something out of a steampunk festival. It needed an up-do but other than that, it was perfect for them. Mandy and her husband were delighted! This could be their first house!
The only problem was with the $70K debt load – most of her husband’s take home was used to cover just their debt payments. The seller’s agent informed them that if they can beat a 10% down payment, the house would be theirs. The seller wanted her house to be passed down to a good family that will treat it right.
Mandy and her husband were less than $5,000 away from that 10% down payment and they considered taking out a family loan when hubby’s former employer suddenly mailed them a check for…(I’m not sure, I didn’t ask but it was enough?)
She engaged with us over messenger, delighted, her hubby’s employer has mailed them a “blessing” check. Now I don’t know her husband very well but I assumed because of the way he was let go during the housing bust that his old boss must have owed him some sort of an apology. When you get good news, it’s important to NOT dash someone’s excitement unless you want to come off a total turkey.
I kept my mouth shut.
Maybe his old employer decided to cut him a check as a “blessing” aka “don’t sue us” – I have no idea. That’s what I assumed “blessing” meant in the corporate world.
Cashing Out 401K Early
Mandy and her husband dropped their “blessing” on the down payment and in a little over a month, they became official homeowners! Her next few updates were positive regarding her move and their new kitchen etc. They had forgotten about their debt snowball plan pretty much completely to be honest.
Until…tax season came around…
“I thought we bought a house so the IRS would give us back some money…but H&R Block people said we owe federal $1,000 and the state another $250! WHAT THE F-”
sends a blurry screenshot
I hand it over to Hubby to look over (because I’m precious that way.) Hub did a quick run through and he said, “um…did you cashed out from a 401K?”
“Yeah that was the blessing check from…”
I start chuckling because I was so close to speaking up before but I didn’t. My money senses were tingling.
I whispered to Hubby “…ohhhh yeah. I thought that sounded weird. That’s not a ‘blessing’. That’s…what’s it called? 401K taxes early withdrawal government something-something.”
“Yeah but it was in the form of a check! What were we supposed to do with it?” Mandy replied back.
Actually I didn’t know that part. All I know was…don’t ever touch your 401K if you have never thrown out your back.
So yeah. That was no blessing, I didn’t even know everything myself until Mandy told me. Their former employer had delayed a great deal but finally released their 401K in the form of a check. This usually happens if the employee does not have enough 401K funds to keep the account open. It’s a small annoyance to the company and most places decide it’s simply not worth dealing with so they just mail the employee a check for the ease.
What Should Have Been Done –
Leaving the money behind with your old employer is a great option if your previous employer has a good 401K plan with strong management and low fees. Hubby had enough with his old employer that he decided to keep that account open instead of transferring.
However, in Mandy’s instance this was not an option for their 401K because 1. there was not enough in there (usually under $5,000) for the company to keep the account and 2. I think the employer had a bad plan and didn’t care much about the legality of it all.
What Mandy and her husband needed to do was indirectly transfer that check to an IRA. They needed to get that money into an IRA within 60 days in order to avoid the tax penalties. You can open an IRA at any bank or brokerage that supports it. Fidelity & Vanguard are great options (I told them.)
Note: typically a direct rollover to an IRA is the simpler of the two. You contact your company’s HR department and follow their guide. Moreover there will be some paperwork and confirmation required but there’s less legwork involved for the employee overall.
401K Taxes & Early Withdrawal Penalties
Cashing out your 401K early is a bad move. Mandy’s husband lost any gains that the 401K have generated over the years. The employer automatically takes away 20% for the IRS before you even see that check. Then it’s taxed like regular income (at your current income bracket) in additional to state income tax if it applies (ie. California state tax for Mandy).
For the grand flourish, another 10% in just penalties is added on at the end of the year. The U.S. government really, really, really discourages people from cashing out their 401Ks.
Life Moves Forward
Unfortunately, Uncle Sam is a hard man when it comes to accidents like this. I sort of feel like there should be forgiveness for those in the dark about the perils of cashing out the 401K early. A lot of Americans are not financially literate and there’s no reason to punish what a person does not know in the first place. That’s why I always echo the importance of financial literacy. But now to look at the bright side – they did get that dream house! You can argue that in the long run, it wasn’t that bad. The amount was relatively forgivable as well in contrast to learning this lesson on a potentially much higher figure. The tax bill will be about $1,300 which they can clear as long as they are diligent. They are back on the debt snowball now and slowly digging out again.
Do you think Mandy and her husband should have waited on the house? Do you think the 401K rollover process too complicated for most Americans? Are the 401K tax penalties too harsh?