If you lose your job and have a 401(k) through your previous company, you may have the option of cashing it out. Many employees choose to take the money instead of keeping it marked for retirement. However, before taking money out of the account, it pays to evaluate your reasons for the withdrawal, as well as the financial consequences that could result from the distribution.
Here are some factors to consider before cashing out a 401(k):
-- Calculate what you will pocket.
-- Consider if the funds are necessary.
-- Look into other ways to access cash.
-- Go through long-term projections.
-- Talk to an advisor.
Calculate What You Will Pocket
The amount you have set aside for retirement will drop significantly if you cash out. The usual 10% early withdrawal penalty will be waived for distributions of up to $100,000 for coronavirus expenses in 2020. However, the amount you take out of a traditional retirement account will be subject to income taxes, which can be paid over three years.
A worker in the 24% tax bracket who withdraws $10,000 from a 401(k) account would owe $2,400 in income tax on the transaction. You can minimize the tax bite if you are able to put some or all of the money back in the retirement account in the three years after the distribution.
Consider if the Funds Are Necessary
Ask yourself if the money is needed to help cover unexpected costs, and if so, evaluate the cause. "A financial emergency is a situation that, if not dealt with properly, can adversely affect your ability to live in your home, your health or your ability to pay for essential items," says Spencer Pringle, senior vice president and senior operations officer at Retirement Clearinghouse in Charlotte, North Carolina. Essential items might include basics such as food, daily transportation, utilities or paying off a defaulted loan.
Look Into Other Ways to Access Cash
If you're going through a tough financial situation, calculate the exact amount you'll need to cover expenses. "Even in a financial emergency, you may only require a portion of your 401(k) balance," Pringle says. "In most situations, you can cash out the amount you need to handle the emergency and keep the remaining amount invested."
Also look at other options for gathering the funds you need. You might be able to tap an emergency fund, take out a loan, refinance your mortgage or cut other monthly expenses to help cover the costs.
Think About Continuing to Invest
Instead of cashing out the 401(k), you may be able to leave it at your previous workplace. "By leaving the funds with the former employer, the 401(k) fees are generally low and investment choices are often broad," says Blake Christian, a partner at HCVT in Long Beach, California, and Park City, Utah.
If you don't leave the funds with your last company, there are other ways to keep the money set aside. "You can roll your existing plan into your new employer's plan if your new employer's plan permits such rollover contributions," says Steven J. Weil, president of RMS Accounting in Fort Lauderdale, Florida.
Another option involves putting the money into a rollover IRA. Rolling the funds into this type of account allows the money to grow on a tax-deferred basis. You will also be able to access the funds at a later point if you need them.
Go Through Long-Term Projections
Money you have set aside for retirement can continue to grow during the coming decades. If you take it out now, you'll lose out on potential interest and earnings that would otherwise accumulate over time. "The costliest part of cashing out is that you miss out on the future growth of the money you withdraw," says Jason Cabler, founder of the Celebrating Financial Freedom blog.
Say you have $20,000 set aside. If you cash it out, you'll forfeit a significant amount of future earnings. Keeping $20,000 in an account with a 10% return for 20 years could amount to $150,000. Another factor to keep in mind involves your goals for retirement. If you plan to maintain your current lifestyle, you'll want to make sure you have enough saved to carry out your retirement goals. Cashing out now could bring immediate, but not long-term, benefits.
Talk to an Advisor
Making a decision that is right for your financial situation is not always a straightforward process. You need to compare the urgency of your immediate needs to your ability to achieve your long-term goals. In some cases you may be able to boost income in other areas, such as taking on a side gig. You may also be able to cut expenses or tap an emergency fund.
"This is a complex area with many choices and possibilities," Weil says. Sit down with a financial or tax advisor to go over your available choices, and use the input to make a decision that meets your current and long-term needs.
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