Early 401(k) withdrawal
February 9, 2001: 8:37 a.m. ET

Think you're in for quick cash? More like penalties, taxes and frustration
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NEW YORK (CNNfn) - When faced with mounting debts, maxing out some or all of your 401(k) may seem like a tempting option, until you consider the old adage, "penny wise and pound foolish."

In response to a reader's question, Heather L. Locus, a certified financial planner in Schaumburg, Ill., and a member of the Financial Planning Association, said that an early 401(k) withdrawal is probably the worst choice someone strapped for cash can make.

Ask the experts a question

I've been unemployed for six months now. I have a 401(k) from my previous employer. I know there are penalties for taking an early payout. With what is in there I could pay off all my debts and still have money left over.

My question is, how do I figure out the penalty and/or any other fees involved? Is there a formula? Also, with this transaction in 2001, I understand it would convert to income, so do I have to pay taxes on it again when I file my 2001 federal and state returns? Or do you have another smarter, logical solution? I would like to make the right decision. Thanks for your help.

Although it is tempting to take the money from your 401(k), it is more than likely the worst place you could take the cash from. If you withdraw the money, your previous employer will withhold at least 20 percent. The actual taxes due will be based upon your marginal tax rate, which you won't know until you file your 2001 return in April 2002.

If you are single and your taxable income (earnings for the year plus the total 401(k) withdraw less deductions and personal exemption) is more than $27,000 but less than $64,500, you will owe 28 percent ordinary income tax plus a 10 percent penalty.

That means if you take $10,000 from the plan you will pay $3,800 in taxes and only have $6,200 to pay your debt. If more taxes are due than what is withheld, you will owe the additional liability on April 15, 2002.

You should see a CPA to get a more accurate estimate based on your earnings and deductions. You also should consult your employer to see whether there will be any costs involved. Most likely there will not be, but if you worked for a small company your investments may have surrender charges.

You didn't indicate what the interest charges are on the debt, but it must be less than the taxes that you would owe. The best solution is probably going to be to keep the debt. If it is on a credit card or high-interest loan and you own a home, you should look into a home-equity loan, as you will probably get a better rate. Good luck with the job search!  graphic