So you’ve recently left your job and wondering what to do with the money you’ve been saving while you were working for your company. Well, now that you have left, the rules for your retirement plan have changed substantially. Here are the good and the bad of keeping money in your 401k plan as opposed to doing a 401k rollover into an IRA:
The Good:
- Usually as long as you have over $5,000 in your plan you will not be forced out and can keep you assets in your former employers plan.
- You can make fund transfers at any time for little to no cost between the investment options.
The bad:
- You cannot make a 401k contribution to this plan anymore and cannot take any loans from the plan.
- You are stuck with the investments the plan offers.
- The plan can change it’s rules, investment options, and even the investment company they work with, which means it’s ever changing and you are the mercy of your former company’s decisions.
- You can take partial withdrawals, however the IRS mandates at least 20% federal tax withholding on any 401k withdrawal
- Some plans start charging fees once you leave the plan.
- The 401k plan is fully self directed meaning that you get no advice on where to move your money and nobody is legally able to give you specific 401k investment advice.
- The 401k is not FDIC insured. If you do not know enough about how this effects your retirement assets do some research on FDIC vs. SIPC coverage and how it effects investments. I will also make a post later regarding this.
Throughout life we all experience changes. I heard a quote once from a wise man who said “When things are really bad things will change and when things are really good things will change as well.” Change is our lives and we must accept that. Now, what does this have to do with your 401k?
Well, when you hear those words “You’re fired!” or maybe you just get laid off as a large business reduction, one of the first things you are going to think about is how are you going to live? Here is where your 401k comes into consideration. Your 401k plan is most likely the largest asset other than your house you currently have and is a lot more liquid than your house, meaning you can get money out of it much easier.
However, 401k plans have a lot of rules and taxes come into play once you make the decision that you need to tap into your retirement savings. Before you start making 401k withdrawals ask yourself these questions:
1.) What places can I get money now to supplement my income?
- Well if you were laid off or fired there is a good chance you can get unemployment income to offset what your job couldn’t produce and this will help keep your hands off of your 401k. Also, think about home equity lines of credit or credit cards as well. These are always only short term fixes and should be able to hold you over for a few months. You should always have emergency assets like these planned in case you do lose your job.
2.) Can I cut back on any expenses?
- Would you really keep living the same lifestyle if you were just fired? I highly doubt it. However, you would be surprised how much people don’t really cut back because they see the large 401k balance looming in front of them. Make sure you cut EVERY corner before tapping into your 401k.
3.) What is my income level (tax bracket) going to be for this year?
- Why is this important? Well, if you cannot cut back on expenses and you are maxed out on lines of credit, a 401k distribution may be the one thing preventing you from bankruptcy (in some cases bankruptcy isn’t all that bad, we’ll get to that later). Basically, if you make less money you pay less to Uncle Sam. If you get fired in October, well your income bracket will still be high and it would probably be advisable to wait until January 1 to make your 401k withdrawal. However, if you get fired earlier in the year, you may not get hit too hard by taxes.
Here is how the penalties work:
If you take a 401k distribution you will be taxed at your income bracket and there will probably be a 10% early withdrawal penalty. You must keep in consideration that any money you take will be income. For example:
If you made $34,000 for 2011, that puts you into a 15% tax bracket considering you file single. Now with the standard deduction that puts your income at around $29,000 or so. Now, the 25% bracket is for people making $34500 and above. So lets say you make a $10,000 withdrawal from your 401k plan:
First of all, your plan will withhold 20% of the withdrawal for taxes (this is an IRS requirement and cannot be avoided unless you do a 401k rollover to an IRA), which brings your check amount to $8,000 considering there is no mandatory state tax. Now, here is what you actually pay:
There would be $5,500 taxed at 15% – $ 825
Now, since extra $4,500 put you above the 15% bracket, that is taxed at 25% – $ 1125
And there will be that 10% penalty on the full withdrawal amount of $10,000 – $ 1000
So, in this scenario, to get $10,000 you are having to give the IRS $2,950 of your hard earned money. This isn’t even looking at state taxes, this is only federal. That is 29.5% of your hard earned money that is gone, never to be seen again.
4.) What are my 401k plan rules?
- Does your 401k plan actually allow you to take partial withdrawals or do you have to take out the full balance? All plans have different rules and a lot of plans don’t even allow partial withdrawals. They surely won’t offer a loan because you aren’t working for the company anymore. So, what is your next best alternative? Initiate a 401k rollover to an IRA and use the rollover IRA to take partial withdrawals from. Most investment firms offer free IRAs or you can go to your local bank and put your money in a money market IRA. Also, rollover IRA accounts do not restrict you on the amount of partial withdrawals you can make and there is no mandatory 20% federal tax withholding on withdrawals, so it may be a better option depending on your circumstances. Also, you can usually do a 401k rollover and then rollover the money from the IRA account into your new companies 401k when you find that job.
On the next post I will go into more detail on the negative effects of taking money from your 401k plan have on your long term future.
What do I need to figure out before I decide on initiating a 401k rollover to an IRA?
There are many factors involved before deciding on rolling over your 401k into an IRA.
First:
What are the fees involved in keeping the 401k plan or rolling it over to an IRA? You need to make sure you are not going to be paying an exorbitant amount of fees with your new retirement accounts.
Second:
What matters more to me? The ability to have many more investment options and the ability to use a financial advisor to guide me on how to invest and how much to save, or would I rather be more limited to my investments in the 401k plan and pay less fees but have to manage everything myself?
Third:
Do I need to consolidate my assets together and be able to have a retirement account to make IRA contributions to? Remember, many times a 401k rollover to an IRA is not a reversible thing and if you do not know all of the facts you could be hurting yourself.
Fourth:
Would it be better to roll my old 401k plan into my new employers 401k account? This is beneficial if you think you may want to use the 401k money you have to buy a house or maybe just use it to pay down some of your debt. Many 401k plans offer 401k loans and right now the interest rate is very low, and keep in mind the interest if only paid to yourself. If you cannot pay back the loan you will pay taxes on the money and probably a penalty, however if you do pay it back you have only paid interest to yourself and will not have any tax consequences. On the other hand, if you initiate a 401k rollover into an IRA, you cannot take a loan from an IRA account and will have to make a withdrawal. The ability to take loans is a great beneficial factor in consolidating your 401k assets into your current plan, however if you do not need the money, more than likely the IRA, with the ability to provide more investment options, will be your best long term retirement strategy.