Cash it in

(Money Magazine) -- Why spend decades carefully cultivating your 401(k) plan, only to fritter away your hard-earned investment gains through taxes or penalties when you change jobs or retire?

With this guide, you can have the thorny withdrawal rules in one place.

Don't touch your it! Your 401(k)'s for retirement. But if you truly need cash, your first option is a loan...

The rules You can borrow for any reason (although some plans are stricter). You pay yourself back with interest - typically at the prime rate plus one percentage point.

Tax alert If you don't pay back the loan in five years, you'll owe income taxes and a 10% penalty (you have longer if you used the money to buy a home). What's worse, you repay any loan with after-tax money - and you'll pay tax on that money again when you withdraw it.

Do only if You've exhausted all other credit sources and you're not changing jobs soon (quit and you'll likely have to settle up the loan immediately).

- Your second option is a hardship withdrawal...

The rules Apart from a loan, you can take money out early only for special needs, such as medical bills, a home purchase, college fees or funeral expenses.

Tax alert In most cases, you must pay income taxes and a 10% penalty on the funds. The exception: The penalty is waived for substantial medical costs.

Do only if It's a dire emergency.

You have three choices when you leave your old firm. Two are fine. One is terrible.

- The first is to do nothing...

The rules Unless you have less than $5,000 in your plan, you can leave it behind. Your savings will keep growing tax deferred in your old 401(k).

Best if Your old job's plan offers a great selection of low-cost funds.

- The second option is to roll it over...

The rules You can move your money to an IRA or the 401(k) at your new job. To do that, contact a fund company or brokerage that has IRAs or your new 401(k) administrator.

Tax alert You don't owe taxes as long as you do a direct rollover that is, the money goes straight to your new 401(k) or IRA without your touching it. If you have the money sent to you instead, your boss must withhold 20% for taxes and penalties. You'll get that money back when you file your taxes, but only if you deposit the plan proceeds (plus the withheld 20%) in an IRA or a 401(k) within 60 days.

Best if You want more investment choices or you want to consolidate all your retirement money.

- The third option is to cash it out...

The rules Nothing is stopping you from walking away with your 401(k) balance - except, you hope, your common sense.

Tax alert Do it and you'll pay taxes and a 10% penalty. Plus, you can't get back that chance for tax-deferred compounding.

Do only if It's a dire emergency.

Now it really gets tricky, but your best move is to hold off on tapping your plan for as long as you can.

- Option 1: If you stay put and wait...

The rules You can let all the money in your 401(k) keep compounding tax deferred until age 70½, when required withdrawals begin.

Best if You have taxable accounts you can draw down first. Leave your plan behind if you like the investment options and other services that your old company provides.

- Option 1, part 2: You can also roll it over and wait...

The rules You can also roll your 401(k) over into an IRA and let that account grow.

Tax alert You must do a direct rollover to avoid having 20% withheld (see Roll It Over under "Changing Jobs" above).

Best if You want the additional investment choices or services that a broker or fund company can provide; you prefer an IRA for your heirs' sake (see "Estate Planning" below); or you want your retirement assets in one place.

- Option 2: Begin withdrawals...

The rules for a traditional 401(k) Once you hit age 55 and retire, you can withdraw your money - either in a lump sum or through periodic payments.

Tax alert You'll pay income taxes on all the money you withdraw, but no penalty.

The rules for a Roth 401(k) All withdrawals are tax-free as long as you are at least 59½ and the account has been open for at least five years.

Tax alert You'll pay income taxes on your investment gains if you withdraw money from a Roth before age 59½. BEST IF | You need the income now. Since you never have to withdraw money from a Roth IRA, try to tap these funds last.

Smart move If you own company stock in a regular 401(k), follow this plan to cut your taxes: Take out the shares directly through what's called a net unrealized appreciation election. You'll pay income taxes only on the cost of the shares when you bought them (or received them as a match). When you sell the stock, you'll pay capital-gains tax (currently 15%) on the difference between the cost and the market value.

- Option 3: Create a steady income...

The rules In about 20% of 401(k)s, you can buy an immediate annuity within the plan and convert some of your savings into income for life. Or you can roll the money over into an annuity on your own (but you probably won't get as good a deal).

Tax alert You'll owe ordinary income tax on your annual annuity payments.

Best if You don't have a traditional pension and you want guaranteed income that you won't outlive.

If you still haven't taken money out when you reach age 70½, you have to act now.

- If you have a regular 401(k)...

The rules Unless you are still at your desk at age 70½, you must start taking annual withdrawals based on your life expectancy - what are called required minimum distributions (RMDs). Your company's plan, though, may require larger payouts.

Tax alert You'll pay income taxes on your annual withdrawals.

- If you have a roth 401(k)...

The rules Same goes with this plan: You must start taking annual withdrawals once you hit 70½.

Tax alert You won't owe taxes.

Smart move To avoid having to take withdrawals altogether - perhaps you want to preserve your retirement account for your heirs - roll your Roth 401(k) into a Roth IRA. Unlike its employer-sponsored counterpart, the IRA version of the Roth isn't subject to RMD rules.