What Happens to Your 401(k) After a Layoff?

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Workers who have spent a significant amount of time at their jobs, and then have been laid off may be wondering what happens to their retirement investments, such as 401(k), when their job ends. Many may be tempted to cash out to tide them over while looking for another job. However, there are some major drawbacks to this action, including penalties and taxes. For the most part, there are three options when you find yourself in this situation. You can leave the 401(k) where it is, roll the account into another investment vehicle like an IRA, or you can move the 401(k) to your new employer’s company. Each option carries with it a series of pros and cons, and in the end, the decision you make will be largely determined by your own circumstance. The following outlines the options for 401(k)s after a layoff, as well as the benefits and disadvantages of each option.

Why Cashing Out is a Bad Idea

Having your employer disburse the funds directly to you in the form of a check is a very bad idea, financially. When you take a direct disbursement via check, the employer has to take 20 percent out to send to the IRS. In essence, you will be getting less than the amount that is in the account. Secondly, the chances are very good that you will become reemployed at some point, and being able to roll that money over into another 401(k) can keep your retirement plans on track. Lastly, any money that you take out is viewed by Uncle Sam as income, and you will be taxed on it. If you are in dire circumstances, and must draw out the cash, then consider only withdrawing a portion of it, if allowable.

Do Nothing

This may be the easiest option, but you should understand that because you are no longer employed with your former company, you will have limited investment choices. Many companies will not allow a former employee to leave the 401(k) as it is, and will instead roll it over into a type of IRA called a Safe Harbor. If your 401(k) account has between $1,000-5,000 in it you could be facing this option.

The positive aspect of this option is that you do not have to do much in order to continue with the savings. You also have a type of protection from creditors taking the money. If you are 55 years of age, then you can actually access your balance with no penalties, while it is protected from garnishment. Each company has varying rules for non-employees who opt to keep the 401(k) active, so make sure that you read your employee’s handbook or speak to HR about the regulations.

Rolling the 401(k) into an IRA

This is actually one of the better options for you as it offers you a greater number of investment choices and greater control over your money. IRA accounts allow you to draw money out of them without penalty for various reasons, including purchasing a home, paying for school or if you need cash. You will lose the creditor protection, however, so if this is a concern, then you will want to reconsider this option.

You should educate yourself about the different types of IRA accounts, because there are quite a few. Basic IRA accounts, Roth IRA accounts and Rollover IRA accounts are the most common. Of particular note is the Roth IRA which requires you to pay the conversion taxes up front, but all of the withdrawals will then be tax-free as long as you hold onto the account for at least five years and have reached the age of 59 ½. The Rollover IRA is a way to avoid the time limit of 60 days, and it will save you the 20 percent withholding tax that will be assessed if you do not transfer assets directly.

Move Your 401(k) into Your New Employer’s Plan

If you get another job within a few months of being laid off, then you can simply opt to move your 401(k) plan from your old employer to your new employer. You will be limited in investment choices, but you will have credit protection and can borrow against that money as long as you are employed with the company. The other advantage is that you do not have to do anything other than sign the release papers authorizing the transfer from one company to another.

Important Considerations for 401(k) Accounts

Keep in mind that there are specific rules when it comes to 401(k) accounts. In general, direct transfers are much better than having the former company cut you a check for the money. This is because once you take a disbursement, the IRS is notified and if you have not reinvested that money within a couple of months, they will see it as taxable income. Additionally, when your employer writes a check for the 401(k) amount, by law, he or she must take out 20 percent to send to the IRS (even if you plan to eventually rollover the amount within 60 days). If this has happened to you already, then you should know that you can get that withheld amount back as long as you go ahead and invest the entire amount back into a tax-deferred account within the 60 days. The amount will be refunded back to you when you file your taxes.