Managing Retirement Assets 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.
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 $5,000.1 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
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
|less 10% IRS penalty
|less remaining federal and state taxes due*
|equals your net after-tax distribution
|*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.
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 IRA, if you have one. Amounts
you contributed to a 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.
|Compare Retirement Plan Distribution
- By leaving your money in your former employer's
plan...you may keep your long-term goals on track by continuing
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
- 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.
Points to Remember
- If you are laid off and you're not immediately moving to a new
company, you generally have three options for your retirement plan
- 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
- 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 IRA, you can also tap into your contributed
portion without incurring a tax penalty.
1An employer must roll assets exceeding $1,000 into
an IRA in your name, unless otherwise directed by you.
© 2011 McGraw-Hill Financial Communications. All rights