Throughout life we all experience changes. I heard a quote once from a wise man who said “When things are really bad things will change and when things are really good things will change as well.” Change is our lives and we must accept that. Now, what does this have to do with your 401k?
Well, when you hear those words “You’re fired!”, maybe you just get laid off as a large business reduction, or just changing jobs, one of the first things you are going to think about is how are you going to live? Here is where your 401k comes into consideration. Your 401k plan is most likely the largest asset other than your house you currently have and is a lot more liquid than your house, meaning you can get money out of it much easier. *Updates have been made to 401k contribution limits 2017*
However, 401k plans have a lot of rules and taxes come into play once you make the decision that you need to tap into your retirement savings. Before you start making 401k withdrawals ask yourself these questions:
4 Questions to Consider Before 401k Withdrawals
1.) What places can I get money now to supplement my income?
– Well if you were laid off or fired there is a good chance you can get unemployment income to offset what your job couldn’t produce and this will help keep your hands off of your 401k. Also, think about home equity lines of credit or credit cards as well. These are always only short term fixes and should be able to hold you over for a few months. You should always have emergency assets like these planned in case you do lose your job.
2.) Can I cut back on any expenses?
– Would you really keep living the same lifestyle if you were just fired? I highly doubt it. However, you would be surprised how much people don’t really cut back because they see the large 401k balance looming in front of them. Make sure you cut EVERY corner before tapping into your 401k.
3.) What is my income level (tax bracket) going to be for this year?
– Why is this important? Well, if you cannot cut back on expenses and you are maxed out on lines of credit, a 401k distribution may be the one thing preventing you from bankruptcy (in some cases bankruptcy isn’t all that bad, we’ll get to that later). Basically, if you make less money you pay less to Uncle Sam. If you get fired in October, well your income bracket will still be high and it would probably be advisable to wait until January 1 to make your 401k withdrawals. However, if you get fired earlier in the year, you may not get hit too hard by taxes. If you were going to make your 401k withdrawals, that would be the time to do it.
Penalties Explained From 401k Withdrawals
If you take a 401k distribution you will be taxed at your income bracket and there will probably be a 10% early withdrawal penalty. You must keep in consideration that any money you take will be income. For example:
If you made $34,000 for 2011, that puts you into a 15% tax bracket considering you file single. Now with the standard deduction that puts your income at around $29,000 or so. Now, the 25% bracket is for people making $34500 and above. So lets say you make a $10,000 withdrawal from your 401k plan:
First of all, your plan will withhold 20% of the withdrawal for taxes (this is an IRS requirement and cannot be avoided unless you do a Rollover 401k to IRA), which brings your check amount to $8,000 considering there is no mandatory state tax. Now, here is what you actually pay:
There would be $5,500 taxed at 15% – $ 825
Now, since extra $4,500 put you above the 15% bracket, that is taxed at 25% – $ 1125
And there will be that 10% penalty on the full withdrawal amount of $10,000 – $ 1000
So, in this scenario, to get $10,000 you are having to give the IRS $2,950 of your hard earned money. This isn’t even looking at state taxes, this is only federal. That is 29.5% of your hard earned money that is gone, never to be seen again.
401k Rollover to IRA
4.) What are my 401k plan rules?
– Does your 401k plan actually allow you to take partial withdrawals or do you have to take out the full balance? All plans have different rules and a lot of plans don’t even allow partial withdrawals. They surely won’t offer a loan because you aren’t working for the company anymore. So, what is your next best alternative? Initiate a 401k rollover to an IRA and use the rollover IRA to take partial withdrawals from.
Most investment firms offer free IRAs or you can go to your local bank and put your money in a money market IRA. Also, rollover IRA accounts do not restrict you on the amount of partial withdrawals you can make and there is no mandatory 20% federal tax withholding on 401k withdrawals, so it may be a better option depending on your circumstances. Also, you can usually do a 401k rollover and then rollover the money from the IRA account into your new companies 401k when you find that job.
Use our 401k Calculator to see negative effects of taking money from your 401k plan have on your long term future.