Unemployment is a scary thing in this tight job market. It’s tempting to look at that 401k plan you amassed over the years at your last employer as nice cash cushion while you get back on your feet and figure out what to do. Before you make any rash moves, though, you should carefully consider the consequences of making such a distribution:
You won’t get the full balance. Your employer must withhold 20 percent of your plan balance to send to the IRS to cover income tax on the withdrawal. In addition, you will be liable to pay the remainder of any income tax due by April 15th of the year following the tax year in which you make the withdrawal.
Unless you are age 55 or older, you will also need to pay a 10 percent early distribution penalty. Worse yet, this additional 10 percent is calculated based on the entire withdrawal – not just what you receive after taxes. So you will have to pay part of that penalty on money you never receive. Note that this age is 55, not 59 ½. This provision applies to those over 55 who have left their company. If you have not left your company, the 10 percent penalty will apply until you turn age 59½.
Exceptions to the 10 Percent Rule
The IRS waives the penalty on early withdrawals from 401k plans if you execute a rollover to an IRA or other qualified retirement plan, or you are over age 55 and have left your employer. For some public safety employees, that cutoff is age 50). If you have medical bills that are more than 7.5 percent of your adjusted gross income, the IRS will also waive the penalty on enough distributions to cover the remainder of the bill. Note that you don’t have to itemize your deductions to take advantage of this provision.
If the IRS levies your retirement account, you will pay income tax (duh!) but you will be exempt from the 10 percent penalty on the withdrawal the IRS forces.
Advantages of IRAs
IRAs, or Individual Retirement Accounts, offer a similar list of hardship exceptions to the 10 percent penalty, but with two notable advantages: With IRAs, you can also make penalty free withdrawals to cover college expenses, and to purchase a home. You may not feel like purchasing a home while you’re unemployed. But if you were sitting on the fence about going back to school and you have the money, you won’t pay a penalty if you tap an IRA to do so.
IRAs also allow you to make penalty free withdrawals to avoid foreclosure or eviction. To take advantage of these provisions, though, you will have to execute a rollover to an IRA. You cannot try it from your 401k, or you will run into the 20 percent withholding and 10 percent penalty issue.
Section 72(t) allows you to avoid the 10 percent penalty by spreading your income from your 401k over the rest of your life expectancy. This can provide a nice cash cushion, though you do lose a bit of tax-deferral benefit on any amounts you take as income.
The Unemployment Trap
There is one significant trap that may affect the unemployed, however: Any withdrawals you take from a 401k plan could offset unemployment compensation. Be sure to take a careful look at your state’s plan rules before you take anything out of a 401k, or you could render yourself ineligible for unemployment compensation altogether – just when you need it most. For this reason, I would be very wary indeed of taking any 72(t) or any other withdrawal unless I did not qualify for unemployment compensation.
Rolling it over
If you do choose to roll it over, I recommend executing a trustee-to-trustee transfer. You can have the 401k plan send you a check directly, but then the clock is ticking. You have only 60 days to complete the rollover. If you screw up, you will pay taxes and penalties on the whole thing at once. Have your 401k plan send the money directly to the IRA custodian. You’ll avoid the 20 percent withholding and you won’t have to worry about slipping up.
If your income will be unusually low this year because of the job loss, it may pay to consider rolling part or your entire 401k into a Roth IRA. You pay your income taxes now, but your tax brackets might be the lowest they will be for the rest of your life. From that point, your Roth IRA grows tax free.
If you have a lot of itemized deductions, don’t sweat the income taxes on small withdrawals. The penalty is bad, but if you can avoid the 10 percent penalty, and then take a taxable withdrawal to pay for an expense that’s tax deductible – like educational expenses directly related to your profession, or job search expenses – then you really have a wash.