Between Jobs? That's the Time to Safeguard Your 401k
It's the kind of story that gives financial planners ulcers: A high-earning, well educated person sabotages his own retirement future by living beyond his means.
James Knaus, a certified financial planner, had a potential client like this. The man recently lost his $125,000-a-year job. He found a new job that paid $80,000 a year, but continued to live a $125,000 lifestyle. To fund it, he cashed out his entire 401k from his old job, paying taxes and an early withdrawal penalty. And today?
"He is in worse condition. He is overspending and is careless with money. I couldn't take him as a client," said Knaus, with LaBrecque, Jackson, Price & Roehl, LLC, of Troy, Mich.
In hard economic times, it may be tempting to tap your 401k if you are between jobs. But the long-term impact could be dire. If you're thinking about cashing in your 401k, consider whether what you spend your money on today will be worth as much as a comfortable retirement in the future.
(While you're still working, plan ahead if you can. Build an emergency account with enough money to fund your lifestyle for three to six months. This cushion can get you through tough times so you won't need to tap your retirement savings.)
Boston Research Group and the Retirement Services Roundtable polled 1,000 workers and reported that 22 percent of employees cashed out their 401ks when they left their employers, intending to spend the money.
Those respondents "concern me because they will be caught short in terms of retirement assets," said Warren Cormier, CEO and president of Boston Research Group.
You generally can't touch your 401k money while you're employed, except to take a loan or hardship withdrawal if permitted. However, when you leave your employer you generally have four options for what to do with your 401k money:
- Leave it in your former employer's plan.
- Roll it to a new employer's plan.
- Roll it to an IRA.
- Cash out.
If you leave your money with your former employer's plan, there will be no tax or penalty worries. Many folks do this because they like the investment options available with their old plan.
Yet, if your balance is small enough (less than $5,000), your employer is allowed to return it to you whether you want it or not. In that case, you could roll it into an IRA. But many folks take the cash.
There are downsides to leaving your money in a former employer's plan. Generally, benefits departments give the best service to current employees. For former employees, the service level falls. Your former employer sees you as a 401k cost. Few employers want to hold retirement savings for departed employees.
Consequently, your opinions about the plan may not mean much. Suppose you left your money behind because you liked the investment options. Your employer can change those at any time.
Also, you are out of the loop. As an employee, you get the most current communication about plan changes. As a former employee, you may not.
"I have seen two situations where people left money at a company and it went out of business," said David Bennett, a certified financial planner with Total Financial Concepts in Los Angeles. They had to research what happened to the money.
"Getting at the money was difficult," he said. "That's not the norm, but it does happen."
Move to New Plan
Moving your money to a new employer's plan lets you avoid penalties and continue to defer taxes. However, you need to find out if your new employer's plan accepts 401k transfers. Many do, but some don't.
The advantage of this strategy is that you can preserve your ability to borrow from your 401k, if your new plan offers loans, said Timothy Cunningham, CFP with EQUIPOISE Wealth Management Inc., in Denver. (You can't take a loan from an IRA or from a 401k with a former employer.)
Plans typically limit loans to $50,000 or 50 percent of your balance, whichever is smaller. If you don't roll your money to your new plan, it could take awhile to build a balance worth borrowing against.
A downside to rolling your money to a new employer's plan is that you may not like the new investment options.
Roll to an IRA
Rolling your 401k to an IRA has no tax consequences, providing you move the money properly.
Hint: Transfer your money to your IRA using what is known as a trustee-to-trustee transfer, in which the money moves directly from the 401k to the IRA.
A big advantage of rolling your money into an IRA is that this generally gives you the broadest array of investment options. Additionally, you may withdraw money penalty-free for qualified home buying and higher education expenses.
In tough economic times it may be tempting to spend your 401k money. But cashing out is expensive and should be considered a last source of funds for daily living expenses. Those most likely to take the money have less than $2,000 in their accounts, said the Employee Benefit Research Institute (EBRI), a non-partisan group. Congress, recognizing these temptations, added several provisions to the 2001 tax bill specifically intended to reduce cash-outs.
If you cash out, you must pay applicable federal, state and local income tax. You'll also owe a 10 percent early withdrawal penalty, if you are under age 55 when you leave your employer.
"To reduce the number of defined contribution plan participants who cash out ... more education and incentives are needed to make them understand the importance of retaining these assets for retirement. Otherwise, ... many workers may be forced to rely on only the funds that have accumulated in their most recent job to provide their retirement income," wrote Craig Copeland, senior research associate with EBRI.
Suppose you are 45 and have $50,000 in your 401k. A withdrawal of that size would put you in the 28 percent federal tax bracket ($14,000 in taxes). Add the 10 percent penalty ($5,000) and you will be left with only 62 percent of your account balance ($31,000). State income tax will reduce your net even more. Remember that 401k withdrawals are taxable income -- so if you earned $50,000 for the year, this withdrawal will give you a total income of $100,000.
Also, if you cash out, you are restarting the clock on your retirement savings. You will miss out on the growth your money has had to date, and future growth.
"It's a desperation move to take money out of a 401k," Cormier said.
Here's another example. Suppose you are 38, with $5,000 in your 401k. Assume your investments average an annual return of 8 percent. By 65, with no further contributions, that will grow to $40,000. Cashing out, "you have given up ... $40,000 of future value," said Paul Gydosh, CFP and managing director of Kensington Wealth Partners, Ltd. of Columbus, Ohio.
Folks who were recently laid off may have no other choice but to tap their 401ks to pay the bills. If this is your situation, try to make your 401k the last resource you tap, Cormier advises.
If you must take the money, roll it into an IRA. Then, "take what you need based on how long you expect your job search to last," Cunningham suggests.
His reasoning is that if you completely drain the account and then find a job quickly, you will have withdrawn more savings than you need and will still face a tax bill and penalty on that money.
Bennett suggests a different strategy if you are in your 50s, have known fixed costs and have a sizable IRA balance. Take penalty-free periodic distributions from your IRA under Section 72(t) of the IRS Code. (You will still have to pay income taxes on these distributions.)
These payments must be roughly equal in value, based on your life expectancy, and taken at least annually. Further, you must take the payments for a minimum of five years or until you reach age 59 1/2, whichever is longer.
Here's an additional suggestion. Suppose you have a $500,000 IRA, but only need the income that $200,000 generates. You can split your IRA in two, putting $300,000 in one and $200,000 in the other. Then, take periodic withdrawals from the latter. When taking periodic withdrawals under Section 72(t) you are only required to calculate your payments based on the IRA from which you are taking the money, not all of your IRA accounts combined.
If you have another job lined up, don't touch your 401k. It may be tempting to take it to pay bills or fund a last-minute vacation, but doing so will reduce your retirement savings over the long term. Pay for today's expenses with today's cash flow.
Gydosh observes that the days when folks stayed with an employer for a lifetime and earned a traditional defined-benefit pension are gone. Few people stay at a job long enough to earn pension credits. The result: "We have the complete responsibility for our own retirement. Any time we can save $5,000 here or there, we need to do that," he said.
This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.