These days, layoffs are a fact of corporate life as companies try to grapple with economic cycles and global competition. One of the first choices laid-off workers face is what to do with their retirement plan assets. Many, confronted with the prospect of meager unemployment checks and a long job search ahead, opt to cash out of their plans.
But cashing out is expensive, involving a large tax bite and forfeiture of one's hard-earned retirement nest egg. Moreover, there are far better ways to make ends meet while unemployed than dipping into retirement savings.
If you get caught in a downsize and you're not immediately moving to a new company, you generally have three options for your retirement plan assets: (1) leave your money in the existing plan; (2) take a cash, or a "lump-sum," distribution; or (3) transfer the money to another retirement savings account, such as an individual retirement account (IRA). Consider the merits of each option.
Option #1 - Stay Put. You may be able to leave your savings in your existing plan if your account balance is more than $5,000.1 By doing so, you'll continue to enjoy tax-deferred or tax-free compounding potential and receive regular financial account statements and performance reports. Although you will no longer be allowed to contribute to the plan, you will still have control over how your money is invested among the plan's investment selections.
Option #2 - Cash Out. You may elect to have your money paid to you in one lump sum or in installments over a set number of years. A lump-sum approach has a number of drawbacks, including a 20% withholding on the pre-tax contributions and earnings portion of the eligible rollover distribution, which the plan is obligated to pay the IRS to cover federal income taxes, and a 10% early withdrawal penalty if you separate from service before age 55. Depending on your tax bracket and state of residence, you may be liable for additional taxes. Taken together, you could lose up to 50% of your money to federal, state, and local income taxes and penalties. An installment approach, whereby distributions are made in substantially equal payments over the participant's and/or participant's and spouse's life expectancy, is not subject to withholding or penalty. But this is a fairly complex option that may require the assistance of a financial advisor.
Option #3 - Roll Over. You can move your retirement plan money into another qualified account, such as an IRA, using a "direct rollover" or an "indirect rollover." Note that traditional plan balances can be rolled into traditional or Roth IRAs, however taxes must be paid on rollovers to a Roth. Roth style plan balances can only be rolled into Roth IRAs. With a direct rollover, the money goes straight from your former employer's retirement plan to your IRA without you ever touching it. The advantages of a direct rollover include simplicity and continued tax deferral on the full amount of your plan savings. IRAs may also afford more investment choices than many employer-sponsored plans. In an indirect rollover, you take a cash distribution, less 20% withholding, but must redeposit your qualified plan assets into an IRA within 60 days of withdrawal in order to avoid paying taxes and penalties. With this approach, however, you'll have to make up the 20% withholding out of your own pocket when you invest the money in the new IRA, or else that amount will be considered a distribution, taxed, and a 10% penalty will be applied.
The Costs of Cashing Out*
Lump-sum cash distribution
|less 20% tax withholding||($2,000)|
|less 10% IRS penalty||($1,000)|
|less remaining federal and state taxes due*||($1,300)|
|equals your net after-tax distribution||$5,700|
*This hypothetical example assumes a federal tax rate of 28%, a state tax rate of 5%, no local tax, and that plan balances are held in a traditional tax-deferred plan. Tax rates vary from state to state and your rates will differ. This example has been simplified for illustrative purposes and is not meant to represent advice. Investment returns cannot be guaranteed.
During times of economic hardship, it may be tempting to take money intended for future needs and use it to supplement a temporary income shortfall. But before choosing a retirement plan cash distribution, look hard at other potential sources to meet your current income needs. Some of these might include:
If, after everything else, you still find it necessary to cash in your retirement savings plan, consider rolling it into an IRA first, then withdrawing only what you need. Also, try to time it after year-end, when you may be in a lower tax bracket. But remember that any funds you take out today will ultimately reduce your retirement nest egg tomorrow.
|Compare Retirement Plan Distribution Options|
1An employer must roll assets exceeding $1,000 into an IRA in your name, unless otherwise directed by you.
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