It’s unavoidable! You turn to the news and there is another round of announcements about the rising unemployment rate, company layoffs or massive corporate cutbacks.
People spend decades contributing to their 401(k) with the anticipation of not having to touch it until they are ready to retire. It’s times like this when that plan goes awry because they were forced to retire, laid off, or find themselves needing to withdraw from their retirement account early, that they must have a solid understanding of how that decision could seriously impact their financial future.
We are all feeling the effects of this ailing economy, unemployed or not. Now it the time to have a plan and make decisions regarding your 401(k) or IRA to ensure it’s working for you. Here are some essential tips for understanding your retirement account and the options available to you…
1) Understand Loans & 401(k) s
If you are employed and considering taking a loan from your 401(K) to get through the “hard times”, understand that you will have to pay it back with interest (typically prime plus one). Although you pay the interest to yourself, as the monies borrowed are not growing for retirement while out of the account, this money is earmarked for retirement. Don’t shortcut the retirement years for quick cash today. If no longer with an employer and you have taken a loan from your account, you will need to pay it back within 60 days of termination to avoid paying income taxes and early withdrawal fees. If you can’t repay the loan, then it is considered defaulted, and you will be taxed on the outstanding balance, as well as assessed an early withdrawal penalty if you are not at least age 59 1/2. A loan is not transferable and cannot be rolled over to another plan.
2) Understand Your Current Account Value
On average, 401(k) account balances declined 18% in 2008, with reports as high as double, or more, in total account value loss for Americans. Since these contributions were done pre-income tax, rolling over a 401(k) now, at a reduced account value, does not provide you any tax credit. If you were hoping to write it off, think again – since no taxes were paid on the amount contributed to the account in the first place, there is no tax break for “realizing” the loss through account reallocation or rollover.
3) Review Your Options
When leaving a company, don’t make any hasty decisions concerning your financial future. Evaluate all of your options and determine which makes the most sense for you. Rolling over your 401(k) to an IRA may not be the best option if you intend to find additional work. Rather you may want to consider rolling over your 401(k) to the new company sponsored plan and take advantage of any benefits your new employer offers, such as fund matching. Employer sponsored plans offer more flexibility for early withdrawal, loans, lower minimum balance requirements and higher before tax contributions.
If rolling over to an IRA is the best decision, understand which type makes the most sense for you. Traditional IRAs allow for tax deductible contributions. Withdrawals can begin by age 59 ½ without penalty, however before 59 ½ there is a 10% early withdrawal penalty on the amount taken prematurely. Withdrawals from IRAs are mandatory by 70 ½, even if the money is not yet needed for retirement. Taxes are paid on the withdrawal amounts. There are a number of investment options within an IRA, allowing one to invest according to their risk tolerance and time horizon.
Roth IRAs are gaining in popularity, as there is no mandatory distribution age, all earnings and principal are 100% tax free and funds within a Roth IRA can be invested in a variety of ways, again, ensuring one invests according to their risk tolerance and time horizon. Although contributions to a Roth IRA are not tax deductible, some experts believe paying taxes on the amount invested today may prove to be profitable decision, as tax rates are likely to increase in the future. Although there are income restrictions for Roth conversions, available only to single-filers making up to $95,000 or married couples making a combined maximum of $150,000 annually, starting next year in 2010 these restrictions are lifted. If considering rolling to a Roth IRA, now may be a good time — account values are likely down and the income tax rates are still relatively low.