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What to Do With the Money in Your 401(k) If You are About to be Laid Off

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Severing ties with your former employer when you’re laid off is a far more complex process than most people realize, especially if you’re enrolled in the company’s various benefit programs. The first issue that comes to mind is whether to continue your health coverage through COBRA, or to find your own health insurance. And right on the heels of that dilemma is what to do about the money in your 401(k).

Greg Womack, President and Principal of Womack Investment Advisers, Inc., an independent registered investment advisory firm, and author of the book Wisdom & Wealth (Beacon Hill Press of Kansas City, 2007), says that your options depend on the way your company’s 401(k) plan is written. Many will permit the ex-employee to leave the funds in the plan and manage them independently. However, some require that the ex-employee roll over the account. The plan may also be written to require your former employer to give you an automatic distribution of funds because the amount of money in the account is below a certain minimum. Keep in mind that if you do get a distribution, you will have to pay taxes on it unless you roll it over into an IRA.

If your former employer allows you the option to leave your funds in the company plan, how do you decide whether it’s better to stay or go? Greg says that all depends on what the 401(k) plan offers in terms of investment choices: “If the plan offers multiple investment choices at a low cost, then keeping the account in the 401(k) may make sense. However, if the plan has limited investment, or sub-par performers, then moving the 401(k) to a IRA Rollover account for more flexibility may be the answer.”

Greg added that your age at the time of the lay off is another factor to consider when you’re deciding whether to maintain your company account. If you’re age 55, you may be allowed to leave the plan intact and take distributions without paying the pre-age 59½ penalty for early distributions. If you take early retirement and you need income from your 401(k), you may be able to get distributions without penalty. On the other hand, if you were to roll over the plan into an IRA, you would be forced to wait until age 59½ to take distributions without penalty. Greg recommends that if you are between the ages of 55 and 59½, you should consult with Human Resources for clarification.

If you’re under age 55 and you decide to leave your money in the account, are you eligible for a hardship withdrawal that eliminates the 10 percent penalty? Yes, says Greg, “The IRS has several exceptions to the early withdrawal penalty. Paying for unreimbursed medical expenses in excess of 7.5 percent of adjusted gross income for the year; paying for health insurance premiums for yourself, your spouse, or a dependent; qualified higher education expense for yourself or certain family members; first-time home buyer expenses ($10,000 lifetime limit); a qualified reservist distribution for military reservists called up for at least 180 days; a qualifying disability; and if the IRS is levying your IRA to pay unpaid, federal income tax liabilities.”

The other way you might qualify for distribution without penalty is under Section 72(t) of the Internal Revenue Code, which lists several exceptions to the pre-mature tax penalty. Here’s how Greg explains it:

“One of the exceptions to this 10 percent premature distribution tax involves taking a series of ‘substantially equal periodic payments’ from your IRA or qualified retirement plan. Substantially equal periodic payments are amounts you must withdraw from your IRA or qualified retirement plan not less frequently than annually for your life (or life expectancy) or the joint lives (or joint life expectancy) of you and your beneficiary. The payments from your IRA or retirement account must continue for at least five years, or until you reach age 59½, whichever is later. If you take a smaller distribution than you should have, or change from one approved method to another, you generally will be subject to the 10 percent premature distribution tax on the taxable part of all payments made to you before you reached age 59½, unless the modification was due to death or disability. In addition, interest may also be imposed.”

If you are about to be laid off and you are enrolled in your company’s 401(k) program, be sure you sit down with the plan administrator so that you understand what your options are, and how much time you have to make a decision about what to do with your money. If you are unsure, especially about qualifying for withdrawals without penalty, it’s a good idea to consult a financial planner to avoid making a mistake that could end up costing you a large chunk of the money you worked so hard to save.


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