By Nancy Opiela, Monster Contributing Writer
If you're among the millions of people who have lost their jobs since the recession started in December 2007, you’re facing some daunting financial questions. One may be: What should I do with my 401k?
While raiding your 401k to pad your bank account during your time of transition may seem appealing, doing so could sabotage your chances of a financially secure retirement. Generally, if you tap your 401k account before age 59½, you’re subject both to ordinary income taxes and a 10 percent early withdrawal penalty. However, if you lose your job and are 55 or older, most plans allow you to access your funds without an early withdrawal penalty, but you’ll still owe taxes and forfeit what could be decades more of tax-deferred growth.
Check with your 401k plan administrator to determine how to keep your retirement nest egg intact. Generally, you have three choices, each with pros and cons: You can leave your 401k plan with your former employer, roll over your account into an individual retirement account (IRA) or transfer your old 401k into a new company’s plan.
Option 1: Leave Your 401k Where It Is
Leaving your assets in your old company’s plan may be convenient, but it limits your investment choices. What’s more, if your account has more than $1,000 but less than $5,000, your ex-employer can transfer your assets into a Safe Harbor IRA with an investment company of their choosing. (If your account balance is less than $1,000, your employer can close your account and send you a check for the balance, withholding 20 percent for taxes.) Some plans also limit the number of transactions, assess extra service fees or restrict beneficiary options for terminated employees.
However, leaving your money in your 401k plan affords you superior creditor protection. Federal law prohibits creditors from attaching 401k accounts, a protection not afforded by most states to IRAs.
Option 2: Roll Your 401k over into an IRA
Rolling your 401k into an IRA affords you a wider universe of investment choices and greater control of your money. For example, you can withdraw cash, penalty-free, for a first-time home purchase or qualified education expenses. Transferring your old 401k plan to an IRA also can facilitate your ongoing investment management and record-keeping, but you give up the flexibility to take a loan from your account and creditor protection.
Note, too, that as of January 1, 2008, you can roll your 401k directly into a Roth IRA. With the Roth, once you pay your conversion taxes, all withdrawals are tax-free (including any growth from the market’s eventual rebound), provided you hold your Roth for at least five years and are at least 59½ years of age. Previously, you had to roll your 401k into a traditional IRA and then move that to a Roth IRA.
Option 3: Roll Over Your 401k into Your New Employer’s Plan
If you land another job right away, you may decide to roll over your 401k into your new employer’s plan. Again, you are limited in terms of investment choices but will enjoy the benefits of credit protection. You also can borrow from your account as long as you work for the employer.
What to Keep in Mind
The most important thing to remember when moving retirement money is to play by the rules. To avoid mistakes, rather than ask your company to send you a check for the 401k assets you plan to roll over, request a trustee-to-trustee transfer, also known as a direct transfer or a direct rollover. Why? Generally, when you take a distribution from a 401k plan to roll over, you must contribute it back into another IRA or other tax-deferred employer retirement plan within 60 days. If you don’t roll over the funds within 60 days, the IRS views it as a taxable and, depending on your age, possibly an early distribution.
Also, if you are issued a check, your employer must withhold 20 percent of your account balance for the IRS -- even if you indicate you will open a rollover IRA. So, in order to invest your entire account balance into your new IRA within the 60 days, you need to come up with that withheld 20 percent to supplement the funds you receive from your employer. Of course, if you invest the full amount into a tax-deferred account within 60 days, you'll get the 20 percent that was withheld back after you file your tax return.
Bottom line? Although losing your job creates financial stress, try not to panic and cash out your 401k. Ideally, your emergency fund or severance package can help you make ends meet while you're between jobs, allowing your 401k money to continue to grow on a tax-deferred basis for your retirement.
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