Photo by Tomi Knuutila on Flickr.com
There are so many issues with losing a job that you hate to think about taxes, but it’s important to think things through. In the last post, I talked about severance pay. In this post I want to talk about your 401(k) and what to do with that money.
First and foremost—it’s important to get your money out of that company’s 401(k) program as quickly as possible. For most people I’m not recommending just taking the money out, I’m recommending what you call a direct trustee to trustee transfer into an IRA. You want to remember that term “trustee to trustee transfer” because that phrase will save you money.
Why take the money out of the 401(k)? Why not just leave it there and roll it into my new company’s 401(k) when I land another job? I get that question a lot. First, you have a lot more control over your money if it’s in an IRA than in a 401(k) so that’s very important. Second, many 401(k) plans are tied into the stock of their company—if your company is laying people off, then that’s a signal that the company’s stock probably isn’t doing so well either. Do you really want to leave your money in a sinking ship? Third, and probably most importantly, if you wind up needing to access that money before you land a new job the IRA is the better place to be as far as taxes are concerned.
What exactly is a trustee to trustee transfer and why should I do one? A trustee to trustee transfer is when you have the money in your 401(k) plan transferred directly to your IRA account without you ever touching the money. Your financial adviser will have you sign the proper forms to make this happen. If you’ve got one of those self-directed plans like in an E-Trade account you’ll be able to find the right forms on their website
But how does this save me money? Because, by doing a trustee to trustee transfer, there are no tax issues. Let me use an example: Let’s say you have $10,000 in your company’s 401(k). You’re in the 25% tax bracket, if you just take the money out, you’ll pay $2,500 in taxes plus another $1,000 in penalties for a total of $3,500 in extra income tax. That’s not good. A direct trustee to trustee transfer is just a tax free way to move your retirement money from one account to another.
Let’s say instead that you want to rollover the money into an IRA but you don’t want to do a direct trustee to trustee transfer. You have your company cut you a check for the full amount of your 401(k) and you’ll handle depositing the money yourself later (You have 60 days to do the rollover). What happens is they cut you a check for $8,000 and give $2,000 to the IRS for taxes. You deposit the full $8,000 into your IRA so you won’t be taxed on that, but you will be taxed on the $2,000 that went to the IRS. That means you’re going to be billed $700 for the $2000 that you gave to the IRS. ($500 for the 25% tax plus another $200 for the 10% penalty.) That’s got to be the craziest thing in the word! You just paid tax on your tax! Oh sure, they’ll refund you the $1300 but that $700 is gone! Zippo! And for what? Don’t fall into this trap.
But I lost my job! What if I need access to my retirement funds? Good point, that happens to a lot of folks. But unless your 401(k) amount is pretty small, I’d still recommend doing the trustee to trustee transfer first, and then only taking out money from your IRA only when it’s absolutely necessary.
Here’s a different example: Jill has an annual salary of $40,000. She gets laid off in December and cashes in her 401(k) which has $100,000 in it. Normally, her annual Federal taxes are just under $3,600, but with the 401(k) added her income taxes are over $40,000 (with the 10% penalty included.) Her taxes for the year would actually be more than what her regular annual income would be. She’s gone from the 15% tax bracket to the 28% tax bracket, and with the 10% penalty for people who are under 59 and ½ years old that’s a 38% tax rate.
But Jill could have done a direct trustee to trustee transfer and saved herself a bundle. Let’s say she does the transfer, but later she needs to access some of that money to make ends meet. We know that she’s been managing on $40,000 a year. Let’s assume that she gets $10,000 in unemployment benefits for the year so she only needs to access $30,000 out of her IRA to stay level. Her taxable income will still be the same so she’ll owe just under $3,600 in regular tax, plus she’ll owe another $3,000 in penalties for the IRA money giving her a total tax bill of $6,600. It’s certainly not a perfect situation; that 10% penalty is painful, but it’s definitely better than paying a 38% tax rate. In this situation, Jill still has food on the table, a roof over her head, and some money still left in her retirement plan.
If you’ve been laid off and have 401(k) benefits left in the company, talk to your tax person and your financial adviser to figure out a plan that’s best for you and your family. You don’t have to go it alone.