Employment Termination & 401(k)s

Tax considerations may make a rollover a lot more attractive.

Tax considerations may make a rollover a lot more attractive.

After the shock and sadness (or joy, if you hated your job) sets in, it's time to decide what to do with your 401(k) from that job. With a little research, you can figure the true cost of taking out money from your 401(k) plan, as well as compare your options to avoid early withdrawal penalties.

Access to Money

A termination of employment is one of the conditions that allows you to remove money from your 401(k) plan. However, that doesn't mean it's categorically a good idea. When you take a distribution, you'll owe not only income taxes on the distribution, but also a 10 percent penalty if you're under 59 1/2 or unless an exception applies. Unfortunately, even if the termination is completely beyond your control, losing your job doesn't exempt you from the early withdrawal penalty.

Penalty Exceptions

If you meet the criteria for an exception, you can remove money from your 401(k) plan without paying the 10-percent penalty, but you'll still have to pay income taxes on the distribution. If you're over 55, you avoid this penalty. You also avoid the penalty if you have medical expenses that exceed the specified percentage of your income, you suffer a permanent disability, or the IRS levies your 401(k) plan.

Loans

If you have any loans from your 401(k) plan, they become due immediately after you get terminated. Unfortunately, even if you just took out the loan shortly before being laid off, if you can't pay it back it's treated as a distribution from the plan. That means it's subject to the same taxes and early-withdrawal penalties as any other distribution. For example, if you have a $15,000 loan and you can't pay it back, you'll owe income taxes on it plus a $1,500 early distribution penalty.

Rollover Alternative

If you don't desperately need the cash and would prefer not to contribute more than you have to to Uncle Sam's coffers, consider rolling over your 401(k) rather than taking a distribution. You can roll the money into any other qualified retirement account, such as a new 401(k) at your new job, or an IRA that you create for yourself. But act fast: you've only got 60 days from the time you take the distribution to put the money in your IRA.

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