Author: Dan Kline, Director, Financial Planning
If you’ve recently lost your job, you probably have some questions about the funds you’ve invested in an employer-sponsored retirement fund. Should you withdraw the amount and use it to fund your expenses while looking for a job, or are there better options for the money you’ve set aside for your golden years?
Since your decision could have a long-term impact on your future, we’re covering three approaches for handling your retirement funds, and discussing the pros and cons of each, to help you make the decision that is right for your situation.
Due to the potential economic hardship of losing employment, you may be thinking about cashing out of your employer-sponsored retirement plan. However, this should only be considered as a last resort, and there are several reasons why.
In the U.S., 64 percent of individuals will retire with less than $10,000 in their retirement savings. Cashing out your retirement account now, even to cover costs related to unemployment, will increase your chances of being financially unprepared for retirement. You’re also likely to receive far less than you are anticipating due to taxes and fees.
To understand the impact of taxation, let’s look at an example. We will assume that a 40-year-old married person with $50k in a retirement plan decides to cash out of his or her employer-sponsored fund. Assuming that they fall into the 22 percent federal and 7 percent state income tax brackets, this individual would only net $30,500 after paying the 20 percent required withholding, the 29 percent income tax obligation and 10 percent in an early withdrawal tax penalty.
If you are over the age of 59 ½ when you lose your job or have lost employment due to the COVID-19 crisis, the situation is a little different, as the penalty for early withdrawal is waived. However, anyone who cashes out of their retirement plan is risking future complications. You’ll be spending a portion of your retirement savings that may take years to earn back and impacting the quality of your retirement.
Another option for handling funds sitting with your employer-sponsored plan is to roll the funds over into another qualified retirement vehicle. These include an IRA, Roth IRA or a plan offered by your new employer.
To avoid tax implications or the possibility of early withdrawal penalties, we always recommend that this be done via a transfer from your old plan’s financial institution to your new one. This approach allows you to move funds without taking a distribution, so you can avoid income tax obligations.
When rolling funds over, it’s a good idea to seek professional guidance from your financial advisor. Unless the money is rolled over according to current guidelines and laws, you could face penalties down the line. For instance, pre-tax contributions and earnings must be rolled into a traditional IRA, not a Roth IRA.
It’s also important to consider your timeline and long-term financial goals. Investing funds for an individual that will retire in five to 10 years requires a different strategy than someone who is decades away from retiring.
Your last option for handling any retirements funds invested in a former employer’s plan may be the easiest. Most employer-provided retirement plans, like a 401(k), 403(b), TSP, etc., allow you to leave your savings in place, assuming your current balance meets the plan’s required minimum amount.
There are several advantages to this approach. The first is continuity. By keeping your retirement savings in the same plan, you’ll continue to work with investments that are familiar to you and have access to the same online tools and advisors.
Most importantly, you’ll still be saving for retirement, helping to ensure that you can continue your current lifestyle beyond your working years. Lastly, most retirement plan fees are lower than you could obtain on your own, so you’ll be saving money over rolling the funds into an account such as an IRA.
While losing your source of employment is a challenging and often frightening experience, your retirement savings are there to make your future retirement possible and enjoyable. Therefore, it’s important to consider every avenue available to you before using your retirement accounts to pay bills during unemployment.
First, evaluate your expenses and determine what is necessary and what is discretionary. Then focus on spreading your severance pay, current income or savings to cover these obligations. Also factor in applying for unemployment benefits before dipping into any retirement accounts.
If you fall short, look first for other options before cashing out your retirement savings. Are there relatives or a friend that might lend you money until you find a job? Is there equity in your home or a life insurance policy that can be used?
Credit cards, used sparingly, are another option that can help you spread your expenses out over time. However, you’ll want to aggressively tackle any debt you incur once you are employed again. Borrowers who carry the average credit card debt and make only minimum payments will take fifteen years to pay off their charges, incurring nearly $4,000 in interest along the way.
On the other hand, if withdrawing the funds in your employer sponsored retirement plan is your only option, consider taking Substantially Equal Periodic Payments (SEPP). With a SEPP plan, disbursements will be divided over five years or until age 59 ½, whichever is longer, but they will be penalty free. Just be sure to consult a financial advisor, because agreements must be crafted and followed to the letter.
Using any of the methods discussed above, however, implies that you’ve overlooked a key financial planning cornerstone. As soon as you are back on sound financial footing, consider starting an emergency savings fund.
Financial planners always recommend that you have at least three to six months of necessary living expenses tucked away for an emergency, such as job loss. Just remember to prioritize replenishing those funds once you are back on your feet.
About the Author
Dan Kline is a Financial Planner with the Private Client Advisory and Financial Planning teams within the Wealth Management group at FNBO. He specializes in providing comprehensive personalized financial planning incorporating investment, tax, protection, retirement and estate planning strategies.