Posted by Paladin on March 25, 2009
As a former Paladin client, I understand that times are tough. The unemployment rate in the U.S. is at the highest in decades. I’m in the trenches with you all, and I hear the pain in everyone’s voices. Unemployment is a scary and uncertain period in your life. But there are some things you can control…your retirement assets.
I am a professional money manager with 20 years experience, and my advice to you is take control of your biggest asset… your retirement account. If you don’t know how to handle your retirement savings while you partner with Paladin in a job hunt, you could end up sacrificing a good chunk of the money you’ve put away in your former 401(k) plan.
Your job search brings many new challenges, but most people don’t consider their retirement savings to be one of them. Nevertheless, you face the real risk of losing a substantial amount of your retirement savings to taxes if you make a wrong move. How could that happen? It boils down to four words: lump sum cash distribution.
One of the last decisions you’ll make at your old job is what to do with your retirement savings. And one of your options will be to take the money in a lump sum cash distribution. It may sound tempting until you learn how it works. First, the amount of the lump sum distribution paid to you will be reduced by a mandatory 20% as prepayment toward federal income tax owed for the year the distribution is made. Since the cash distribution will be included as regular income for the year received, your actual federal tax liability may be even higher than the 20% withheld when you file your tax return, and you may also be subject to state income taxes. What’s more, if you’re under 591⁄2, an additional 10% federal penalty tax and applicable state additions to tax may be imposed on the distribution.
When you do the math for a hypothetical 30-year-old in the 25% federal tax bracket facing a modest distribution of $10,000, you see that after taxes, including early withdrawal taxes, that means getting to keep no more than $6,500. And, state taxes could take another bite. Maybe worst of all, by taking a cash distribution, you run the risk that the money you actually receive will burn a hole in your pocket, rather than continue growing tax deferred for your retirement.
What Are Your Other Choices?
- Leave your retirement savings unmanaged in your former employer’s plan.
- Transfer your money to your new employer’s plan, which may have the same limitations as your current 401(k) such as limited investment options and high administration costs.
- Contact an investment advisor to help you arrange for a quick and direct rollover into an IRA with an investment advisor who will put you in control.
The important feature the above options share is that they let you avoid the immediate tax burden you’d have if you cashed out with a taxable lump sum distribution. Leaving your money in your former employer’s retirement plan or moving the money to a new employer’s retirement plan is fine. You’ll be subject to any investment choice limitations that might be associated with these respective plans. Your best option and what you should do is rollover your money to an IRA. Educate yourself as to why this may be the right move for you.