There are many challenges when you lose your job, including what to do with your 401(k) plan. This article outlines some of the things you should consider, but it does not replace the professional advice of a financial planner.
There are three basic options:
- Withdraw the money;
- Keep the 401(k) (this may not be an option, however) or
- Roll the account to an Individual Retirement Account (IRA).
This first part of planning for your 401(k) is determining your account balance. Most 401(k) plans have matching contributions, but with those come vesting schedules — the time frame at which you are entitled to a percentage of the match. Your statement will detail what percentage you are vested, and also the dollar amount, so you can determine how much you have in your 401(k) plan between your contributions, the company contributions, and any earnings on the underlying investments.
If your account balance falls below a certain amount (currently $5,000), you may be required to take a “Mandatory distribution” or “cash out”. If your balance is at least $1,000, your account balance will be directly rolled into an IRA for you, unless you elect otherwise.
Also, you should be prepared to address any 401(k) plan loans you may have outstanding. If you have a plan loan, you may want to retain the plan until the loan is repaid (you will need to make arrangements with the plan administrator about how this will be done, as deductions from your pay are no longer an option).
The first option, withdrawing the money, may be necessary given your finances. But give this option careful consideration as it should be your last resort for cash. This is because the money withdrawn is immediately taxed as ordinary income and, if you are under the age of 59 ½, will be subject to a 10 percent penalty (if the plan is a SIMPLE 401(k), there is a 25 percent penalty if the money is withdrawn within the first two years of participation).
Reasons to consider retaining the 401(k) include having access to a loan provision (if your plan has one) and if you are at least age 55 when you leave your company. A special Internal Revenue Service (IRS) rule allows access to qualified retirement plans at age 55 without the 10 percent penalty if the account holder is at least 55 and separated from service. The withdrawals will still be taxable as ordinary income, but at least there wouldn’t be a penalty. There are other exceptions to the early withdrawal penalty as well that are available to qualified plans only, qualified plans and IRAs, and IRAs only.
In addition, some 401(k) plan trustees may have negotiated for very low expenses for the underlying investments and/or administration fees. On the flip side, some plans have very large expense ratios and the plan participants may not even be aware of how much they are paying.
If you have company stock within your 401(k), there is special (capital gain’s) tax treatment available, provided you follow a few simple rules. If you roll the 401(k) over to an IRA, you may lose this benefit. You will want to discuss this strategy with your advisers (financial, tax, legal) prior to taking action.
But there are good reasons to roll the 401(k) to an IRA. For one, you can actually have access to the funds for 60 days before they must be placed in the IRA. This is generally not recommended because taxes are withheld (typically 20 percent federal) when you make such a withdrawal and you’ll need to replace the full amount into the IRA, or be subject to taxation and possibly an early withdrawal penalty. Also, any number of things could happen in those 60 days and you may be a victim of poor record keeping or miscommunications, causing taxes and penalties when appropriate.
Making a direct rollover into an IRA avoids withholding taxes. The primary benefit of rolling the account over into an IRA is that it allows you save and/or invest as you wish, as you are no longer limited by the menu of funds offered in the 401(k) plan. This is probably the biggest benefit; having control over the funds themselves.
You also may have the option of rolling an inactive 401(k) plan to a new 401(k) plan with a new employer, if the plan allows for rollover contributions. The primary benefit of this option is that, if you are still employed with an active 401(k), you are not required to start taking required minimum distributions from the plan until you have separated from service (rather than at 70 ½ as is the case with inactive 401(k)s and IRAs).
Rolling the plan’s assets into a Roth IRA is also an option that may be appropriate for you. Be advised that, if you choose this option, the amount rolled into the Roth IRA is immediately taxable as ordinary income (but not subject to the 10 percent early withdrawal penalty if you’re under 59 ½). The benefit of the Roth IRA is that qualified distributions are received income tax-free; a nice option if income tax rates increase.
It may be helpful to know that both qualified retirement plans and IRAs are protected from creditors (only the owner’s creditors, once left to a beneficiary, the protection may be limited or eliminated). In the event of a bankruptcy, qualified plans are protected without limit and IRAs are protected up to $1 million dollars, under current law. Qualified plans are protected even if they are rolled into an IRA, above and beyond the $1 million separate protection limit.
FPA member Amy Jo Lauber, CFP® is the President of Lauber Financial Planning in Buffalo, NY.