Cashing Out a 401(k) After a Layoff: The Tax Bill Nobody Mentions

Right after a layoff, the plan administrator sends you a packet. Somewhere in it is a form that lets you take your whole 401(k) balance as a check. When rent is due and the job market is cold, that form looks like a rescue.

Sometimes it is the right call. Often it is an expensive one. The money comes out with withholding already taken, it lands on your tax return as income, and if you are under 59 and a half it may carry a 10% additional tax. People who cash out without running the numbers are some of the most common new IRS debtors I see after a job loss.

Three separate hits on one withdrawal

Hit one: mandatory 20% withholding

Under IRC Section 3405(c), when a distribution is an "eligible rollover distribution" from an employer plan, the payor "shall withhold from such distribution an amount equal to 20 percent." Most 401(k) cash-outs after you leave a job fit that definition. The only way around the 20% is a direct rollover, where you elect under Section 401(a)(31) to have the money paid straight to another eligible retirement plan, such as an IRA or a new employer's plan.

So a $40,000 balance usually produces a check for $32,000. The other $8,000 goes to the IRS as a prepayment of your tax.

Hit two: ordinary income tax

The taxable part of the distribution is income in the year you receive it. It gets added to your wages, your severance and your unemployment. That 20% withheld is a credit against your tax, but it is not necessarily the full tax. If the distribution pushes you into a higher bracket, you may owe more when you file.

Hit three: the 10% additional tax

IRC Section 72(t)(1) increases your tax by 10% of the taxable portion of an early distribution from a qualified retirement plan. "Early" generally means before age 59 and a half. Unlike the 20% withholding, this is not a prepayment. It is an extra tax, and it is not withheld unless you ask for more withholding.

Add those together and a $40,000 cash-out can leave you with a check for $32,000, a return that still owes money, and a 10% additional tax of $4,000 on top. Nobody puts that math on the election form.

The exceptions that matter after a job loss

Section 72(t)(2) lists the situations where the 10% additional tax does not apply. Several of them line up with the life events this site covers. Each one has strict conditions, and the plan's Form 1099-R may or may not code the distribution correctly, so read the fine print.

Separation from service at age 55 or older

Section 72(t)(2)(A)(v) exempts distributions "made to an employee after separation from service after attainment of age 55." The Form 5329 instructions describe this as separation in or after the year you reach age 55 (age 50 for qualified public safety employees and certain others). Two warnings. First, this applies to distributions from the employer plan you separated from. Section 72(t)(3)(A) says the age 55 exception does not apply to distributions from an individual retirement plan. If you roll the 401(k) into an IRA and then withdraw, you lose this exception. Second, the separation has to be from the employer that maintains the plan.

That second point catches people. If you are 56 and just lost your job, the money in that employer's 401(k) may come out without the 10% additional tax. Move it into an IRA first and the same withdrawal may be penalized.

Health insurance premiums while unemployed (IRAs only)

Section 72(t)(2)(D) exempts distributions from an IRA to pay health insurance premiums for you, your spouse and dependents after you lose your job, if you received unemployment compensation for 12 consecutive weeks because of that separation. The distribution has to be made in the year you receive unemployment or the following year, and the exception ends once you have been reemployed for at least 60 days. It applies to IRAs, not to 401(k) plans.

Medical expenses

Section 72(t)(2)(B) exempts distributions up to the amount you could deduct for medical expenses under Section 213, which is generally the unreimbursed amount above 7.5% of adjusted gross income, and you get this exception whether or not you itemize. If the job loss came with a medical crisis, read retirement withdrawals for medical bills.

Emergency personal expense distributions

Section 72(t)(2)(I) allows one emergency personal expense distribution per calendar year to cover "unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses." The cap is low: the lesser of $1,000 or the amount by which your vested balance exceeds $1,000. It will not cover a long stretch of unemployment, but it exists.

Disability and terminal illness

Distributions attributable to disability under Section 72(m)(7), and distributions after a physician certifies a terminal illness, are also excepted. If a health event caused the job loss, look at these first. See the disability exception to the early withdrawal tax.

The 60-day escape hatch

If you already took the check and regret it, you may still have time. IRS Tax Topic 413 explains that you have 60 days from the date you receive an eligible rollover distribution to roll it over to another eligible retirement plan. Roll it over and that portion is not taxed now.

There is a catch. The plan withheld 20%. To roll over the full distribution and avoid tax on all of it, Tax Topic 413 says you must "add funds from other sources equal to the amount withheld." If you only roll over the $32,000 you received, the $8,000 that was withheld is treated as a taxable distribution, and the 10% additional tax may apply to it. You get the withheld amount back as a credit on your return, but not until you file.

If you had an outstanding plan loan when you left, the plan may offset the loan against your balance. Tax Topic 413 notes that for a qualified plan loan offset amount, you have until the due date of your return, including extensions, for the year of the offset to complete the rollover.

Reporting: Form 1099-R and Form 5329

The plan reports the distribution on Form 1099-R. Box 7 carries a distribution code. If the code is 1 (early distribution, no known exception) and you really do owe the 10% on all of it, the Form 5329 instructions say you can skip Form 5329 and report the additional tax directly on Schedule 2. If an exception applies but the 1099-R does not show it, you file Form 5329 and enter the correct exception code: 01 for separation from service at 55, 03 for disability, 05 for medical expenses, 07 for health insurance premiums while unemployed, 20 for terminal illness, and 23 for an emergency expense distribution.

Do not assume the plan got it right. Plans often do not know about your medical bills or your unemployment checks.

Before you cash out, ask these questions

• Am I 55 or older in the year I separated? If yes, do not roll to an IRA before taking the money you need.
• Can I take only what I need instead of the whole balance? Partial distributions limit the damage.
• Will the withdrawal, plus severance and unemployment, push me into a higher bracket this year? See how severance pay is taxed.
• Do I qualify for any 72(t)(2) exception, and will the 1099-R reflect it?
• Can I set money aside now for the tax that the 20% withholding will not cover?

If the cash-out already created an IRS balance

This is one of the most common ways a layoff turns into a tax debt. File the return on time even if you cannot pay. Then look at the payment options laid out in owing the IRS after losing your job. If the money is already spent and you are still unemployed, the IRS has hardship procedures, but they require full financial disclosure and they do not stop interest.

The 401(k) can be a lifeboat. Just know the price of the ticket before you climb in.