When you leave your job, you may have several choices regarding your company's retirement plan savings:
If you're happy where it is and the company permits, leave it there. If you want more investment flexibility and control, roll it over into an IRA (see the section on Rollovers to Your IRA). When you are reemployed, if you like the choices that your new employer's plan offers, move it there. But whenever possible, avoid spending it.
IMPORTANT NOTE: Limitations and restrictions may apply for the retirement options listed above. Using your retirement plan savings for non-retirement purposes should always be your last resort.
If you're really short on cash, you may have borrowing options in your 401(k) plan. Although not common, some employers will allow you to leave your retirement plan savings intact when you terminate employment prior to retirement, and allow you to borrow without considering it a withdrawal. (See the section on Borrowing from your 401(k) Plan)
IMPORTANT NOTE: Make sure you check the terms and conditions of your employer's 401(k) plan before your employment ends. If you have an outstanding loan when you leave, your retirement plan generally requires you to pay it back. If you can't pay the loan off, it will be considered a withdrawal of funds. If you're under age 59½, in addition to paying ordinary income tax, you'll have to pay a 10% penalty (with limited exceptions) on the taxable portion of the withdrawal.
Generally, if the amount in your plan is under $5,000, your account balance may be rolled over automatically to a designated IRA unless you elect to have the distribution transferred to a different IRA or a qualified plan, or to receive it directly. If you were born before 1936 and want to use ten-year averaging tax treatment on a withdrawal, your retirement plan account balance must be segregated from direct IRA contributions.
Once you move your retirement funds into an IRA, you no longer have the privilege of borrowing your money. If you need money, you'll have to withdraw it—and pay taxes and a possible penalty.
Some Exceptions to the 10% Early Withdrawal Penalty before Age 59½
The 10% penalty doesn't apply to:
* This 10% penalty exclusion does not apply to IRAs.
** These 10% penalty exclusions apply only to IRAs.
Protect your Retirement Assets
One last word when leaving a job, particularly if you've been laid off: You may be tempted to use the money for day-to-day living expenses. Exhaust every other possibility before you withdraw your money. Between income taxes and a possible penalty tax, you will pay a tremendous price in both the short and long term if you invade your retirement account. Here's why:
Suppose you are 40 years old, you are in the 25% tax bracket, and you need $10,000. You have no other savings. You decide to withdraw $10,000 from your company retirement plan. You'll have to withdraw another $5,385, a total of $15,385 just to net $10,000. Why so much? The government requires you to pay income tax as well as a 10% penalty (assuming you're under age 59½). See above for information about exceptions to the 10% penalty.
How Much Will You Actually Have to Borrow to Net $10,000?
minus income tax at 25%
minus 10% penalty if under age 59½
Since you are required to pay income tax and a penalty tax, it is actually costing you 54% more. That's the short-term effect of taking the withdrawal.
The long-term effect—assuming a 7% tax-deferred return and you don't retire until age 65—is that the $15,385 could have grown to $83,501 in 25 years.
SUGGESTION: If you're really short on cash and you need to pay bills, you have 60 days from when you receive the check to complete the tax-free rollover. You're also able to withdraw your funds from an IRA once every 12 months for a sixty-day period before putting it back into your IRA or transferring it to a new tax-deferred account. As long as you complete the transfer, you're home free. But if you can't come up with the funds, you'll owe taxes and get hit with the 10% penalty (with limited exceptions). If you must use the money temporarily to pay bills, your best bet is to keep the money in an IRA money market where you have easy access to it and withdraw only as much as you need. You also won't have to worry about a drop in price if you need to withdraw the funds, as you would if it were invested in stocks and bonds.
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