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Managing Retirement Assets in the Event of a Layoff

 

Being laid off is often unavoidable. But losing your retirement nest egg at the same time can be prevented. Find out what your retirement savings plan distribution options are and identify some better short-term funding sources.

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 can be expensive, involving a large tax bite and forfeiture of one's hard-earned retirement nest egg. Moreover, there may be 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 potential 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% additional federal tax if you separate from service before age 59½ (55 in some circumstances). 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, may help you manage some tax liabilities. But this is a fairly complex option that may require the assistance of a financial advisor.

Option #3 -- Roll Over. You can move your retirement plan money into another retirement 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.2 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 the withheld amount will be considered a distribution, subject to ordinary income taxes, the 10% additional tax, and potential state taxes and penalties.

 

 

The Costs of Cashing Out*

Lump-sum cash distribution

$10,000

less 20% tax withholding

($2,000)

less 10% additional federal tax

($1,000)

less remaining federal and state taxes due*

($1,300)

equals your net after-tax distribution

$5,700

*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 accounts 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 a way to tap into the equity in your home. They offer comparatively low interest rates, and interest payments are generally tax deductible. It may make sense 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. See IRS Publications 590a and 590b for more information.

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 Options

  • 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 penalties.

  • 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.2

 

Source/Disclaimer:

1An employer must roll assets exceeding $1,000 into an IRA in your name, unless otherwise directed by you.

2Fees and investment expenses may be higher in an IRA than your plan, and if your plan assets include employer stock, you may end up ultimately paying higher taxes on any potential gains on that stock. Also, if you plan to work past age 70½, an employer-sponsored plan may allow you to delay required minimum distributions.

 

 

 

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

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