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1. In the Event of a Layoff...
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.
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2. Evaluate Your Options
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. 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.
The Costs of Cashing Out
| Lump-sum cash distribution | $10,000 |
| less 20% tax withholding | ($2,000) |
| equals the amount in your pocket | $8,000 |
| Lump-sum cash distribution | $10,000 |
| less 10% IRS penalty | ($1,000) |
| less ordinary federal and state income tax* | ($3,300) |
| equals your after-tax distribution | $5,700 |
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 only be rolled into traditional IRAs and new 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 and a 10% penalty will be applied.
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3. Consider Other Short-Term Funding Sources
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:
- Savings accounts or other liquid investments, including money market funds or other easily liquidated investments. With short-term interest rates at historically low levels, the opportunity cost for using these funds is relatively low.
- Home equity loans or lines of credit are an excellent way to tap into the equity in your home. Not only do they offer comparatively low interest rates, but interest payments are generally tax deductible. The best approach here may be to set up an equity line of credit beforehand, while you are employed, so that funds will be available when you need them.
- Roth contributions. If you do find it necessary to resort to using some of your retirement savings, consider first cashing in the contributed portion of your Roth-style plan or Roth IRA, if you have one. Amounts you contributed to a Roth-style plan or Roth IRA can be withdrawn tax and penalty free, since you've already paid taxes on them.
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.
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4. Compare Retirement Plan Distribution Options
By leaving your money in your former employer's plan...you may keep your long-term goals on track by continung to pursue tax-deferred growth potential.
By taking a lump-sum cash distribution... you may satisfy an immediate need for cash, but impede the long-term growth potential of your retirement portfolio and expose yourself to substantial tax liabilities and premature withdrawal penalties.
By making a direct rollover to an IRA... you will continue to pursue tax-deferred or tax-free growth while potentially having greater control over the assets.
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Summary
- If you are laid off and you're not immediately moving to a new company, you generally have three options for your retirement plan assets.
- The first option is to leave your money in the existing plan, which you may be able to do if your account balance is more than $5,000.
- The second option is to take a cash, or a "lump-sum," distribution. But this approach will trigger a mandatory 20% withholding, a 10% penalty fee, and ordinary income tax on some or all balances withdrawn.
- The third option is to roll over the money to another retirement savings account, such as an IRA. The advantages of a direct rollover include simplicity and continued tax deferred or tax-free growth on the full amount of your plan savings.
- Other potential income sources to meet your current needs include savings accounts, other liquid investments, and home equity loans or lines of credit.
- If you have a Roth-style plan or Roth IRA, you can also tap into your contributed portion without incurring a tax penalty.
Checklist
- Consider delaying your anticipated retirement date in order to make up for lost wages and missed investment opportunities.
- If you decide to transfer money from a former employer's plan to an IRA, opt for a "direct rollover" that relieves you of the responsibility to withdraw and then re-deposit the money yourself.
- Begin replenishing your emergency savings account as soon as you start working again.
- Sign up to participate in your new employer's retirement plan as soon as you become eligible to do so. Contribute as much as possible.
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