Layoffs are a fact of corporate life as companies grapple with economic cycles and global competition. If you get caught in a corporate downsizing and you are not immediately moving to a new employer, you generally have three options for your retirement plan assets:
- Leave your money in the existing plan.
- Take a cash or “lump sum” distribution.
- Transfer the money to another qualified retirement account, such as an individual retirement account (IRA).1
Consider the merits of each option.
Option #1: Stay Put
You may be able to leave your savings in your existing plan.2 By doing so, you can potentially continue to enjoy tax-deferred or tax-free compounding and receive regular 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. A lump-sum approach has a number of drawbacks, including 20% withholding on the pre-tax contributions and the earnings portion of the eligible rollover distribution (to help cover your ordinary income tax liability) and possibly a 10% additional tax on early withdrawals if you take the distribution before age 59½. Depending on your state of residence, you may be liable for additional taxes.
Option #3: Roll Over
You can move your retirement plan money into another qualified account, such as an IRA, using a “direct rollover” or an “indirect rollover.” Generally, traditional plan balances can only be rolled into traditional IRAs and designated Roth account 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 contributions and any earnings. IRAs may also afford more investment choices than the employer-sponsored plan.
Generally, in an indirect rollover, you take a cash distribution, less 20% withholding, but must redeposit your qualified plan assets into an IRA or another plan within 60 days of withdrawal to avoid paying taxes and penalties. With this approach, however, you’d have to make up the 20% withholding out of your own pocket when you invest the money in the new IRA or plan, or else the withheld amount would be considered a distribution, so ordinary income tax and possibly the 10% additional tax would apply.
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 remember that any funds you take out today will reduce your current retirement savings.
Before choosing a cash distribution from a retirement plan, consider other potential sources to meet your current income needs. For example, savings accounts and money market accounts are easily liquidated. With short-term interest rates at historically low levels, the opportunity cost for using these funds is relatively low.
1Once you are eligible for a new employer’s plan, you might also have the option of rolling your assets to this plan.
2In general, if all requirements are met, the plan administrator of your former employer may effect an automatic rollover of retirement assets exceeding $1,000 but less than $5,000 into an IRA in your name.