Distribution Series Part 1: Pre 59 1/2 options
Unfortunately, in a struggling economy the level of layoffs rises. On top of everything else, newly separated employees must also decide what they should do with their 401(k). Often times, the first instinct is for people to take the money out for living expenses. Today, I would like to discuss what you can expect when taking a cash payment prior to reaching the age of 59½, what other options are available to you and why these options are usually preferable.
As a recently separated employee, you have several options on what to do with the money in your account. The options include leaving the money in the plan, cashing out, rolling over to your new employer’s plan, or rolling to an IRA. Here is a breakdown of each option:
1. Leaving the money in the plan
Generally, you are allowed to keep your money in the plan as long as you have a vested account balance of at least $5,000. Be sure to check the plan documents or contact your retirement plan representative for the specific policy on your account.
2. Cashing out
Most people are unaware that the dollar amount of their account and the dollar amount they will receive when they cash out are different. Since most contributions are made on a pre-tax basis, receiving a check that matches your statement is unlikely because you will be required to pay taxes and penalties on this money.
Let’s look at what would happen to a $10,000 pretax balance upon distribution. First, the 401(k) plan provider will be required to withhold at least 20%, or $2,000 for federal tax purposes. In addition, some states have a mandatory state tax withholding anywhere from 2% to almost 8%. In Kansas, where I live, 5% is the mandatory state tax. This means if I took the distribution mentioned above, I would receive a check for only $7,500 ($2,000 withheld for Federal tax, and $500 state tax).
Be aware that this may not be the only taxes you have to pay. During tax season the following year, you will receive a 1099r showing the $10,000 as earned income, and as a result you may end up owing more in taxes. In 2007, the average household income was $50,233, which would put you in the 25% tax bracket. Therefore the average individual would need to pay an additional 5% in taxes on what was cashed out. Furthermore, if you are under the age of 59½ there would be an additional 10% penalty assessed. This means an extra $1,500 of taxes and penalties would be assessed the following April. So in the end, you may only have $6,000 of your original $10,000 balance.
Please Note: For the reasons outlined above we typically recommend against this option.
3. Rolling to your new Employer’s plan
By rolling over to your new employer’s plan, you would be doing so on a tax-deferred basis, which means no taxes or penalties would be assessed. This would also allow you to consolidate your two accounts into one, thereby making it easier for you to manage and monitor. I know it’s hard enough to keep track of one plan let alone doing so for two or more plans. The ability to consolidate plans and the tax-free rollover are two major advantages for this strategy.
4. Rolling to an IRA
You still get to rollover without getting taxed, but you don’t get the ease of monitoring a single account. However, there are other advantages to an IRA over a 401(k). Typically instead of being limited to maybe 10-30 funds in a 401(k), you open yourself up to thousands of mutual funds with an IRA. This means you can further diversify your account. Other advantages include the following: tax benefits to beneficiaries in the case of your passing, certain funds become available that might be closed to investors in a 401(k) and partial distributions can be taken without extreme penalties. In an IRA, you have the ability to take partial distributions as needed to help pay for living expenses. For someone looking for a job and needing money to pay bills, this might be the best option.
Each individual’s situation is different based on your tax bracket, the state you live in, plan rules and how much of your account was pre-tax or after-tax money. We know life can take some hard turns; if you have to withdrawal from your 401(k) or IRA we recommend considering a partial distribution and taking out only what you need to cover your living expenses. I also recommend you contact your employer to discuss the specific plan rules that apply to you and weigh all your options carefully.
As always, feel free to contact any Smart401k advisor to talk through your situation; you can reach us at info@smart401k.com or 877.627.8401. We would be happy to walk through your options with you.