Last newsletter I wrote about the pros and con’s of 401k loans – for a financial emergency. Today I would like to continue this thread, but with a little different spin. What about the friend, or the employees that your company was forced to let go or severed from service in order to down size? Many of these ex-employees may simply take a lump sum distribution from their 401k plan – as they may feel their immediate needs require it, and do not know of the options.
Just a little education from you or in the exit interview could present them with alternatives. If nothing else, you should be encouraging them to seek out advice. After all, this is a fairly unique situation that doesn’t happen very frequently (hope not anyway). So, no one should expect to know all of the options in this case. Here are some things you should know:
If you are under 59 ½, and you do not request a “hardship withdrawal”, then you start with a 10% penalty to the IRS. Additionally, every dollar withdrawn is taxable. This option can get very expensive, costing you upwards of 50% in taxes and penalties by time it’s done.
If you are over 59 ½, you are in the clear – at least as far as the 10% penalty is concerned. Yet, every dollar withdrawn is still taxable, and indeed most 401k plans require that they automatically withhold 20% for Federal taxes upon your withdrawal request.
If you are 55 or over when separation took place, like # 2 – you can avoid the 10% penalty.
If you can prove a “hardship”, you can avoid the 10% penalty. While being unemployed may feel like a hardship, it does not qualify per the IRS. Here are some things that do:
Permanent disability (not really a choice)
Monies withdrawn to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income).
Payments to ex-spouse: to alternate payee under a qualified domestic relations order
Taxes to the IRS – if the IRS puts a lien on your account, monies withdrawn are not subject to the 10% penalty.
Lastly, if you are under 55, then you may want to consider a rollover to an IRA, followed by what is called a 72(t)**. This allows you to take substantially equal payments from your account until age 59 ½ or 5 years – which ever is longer. This strategy too, can avoid the 10% penalty.
In my opinion, the bottom line is still: the 401(k) should be the last resort. Like your “root cellar”, you should only eat from it when you must; otherwise it might not be there when you need it most.
Investing involves risk including the potential loss of principal. No investment strategy, including diversification or asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is not a guarantee of future results. Please note that rebalancing investments may cause investors to incur transaction costs, and when rebalancing a non-retirement account, taxable events will be created that may increase your tax liability. Rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment.
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