Layoff Triggers 401(k) Options

The new era of rising layoffs means more workers will face what human resources people refer to as “a benefit event”--a rollover or cash distribution of a worker’s 401(k) retirement savings assets because of a job change or retirement.

If you find yourself in that position you have a number of options for your retirement nest egg. What you shouldn’t instantly do, experts say, is simply decide to take that money in cash and spend it.

Yet in recent years the cash-out option is exactly what most people have chosen, surveys show. While that may be unavoidable for some laid off workers with meager other savings, a cash-out often means that the “benefit event” benefits the tax collector more than you.

“It’s so tempting to just spend that check, especially for someone in their 20s who may figure, ‘It’s only $3,000 anyway,’ ” said Ed Slott, a certified public accountant in Rockville Centre, N.Y., who publishes an IRA newsletter.

“But if you just roll it over [into another retirement account] and pretend you don’t even have it, you will see it pay off exponentially over time,” he said.

The 401(k) plan, named for a section of the U.S. Tax Code, has become a cornerstone of the nation’s retirement system, with $1.8 trillion in assets. About 42 million people participate in the plans, with an average balance of about $42,000, according to consulting firm Cerulli Associates.

In a 401(k), and in similar plans for teachers and government employees, workers contribute a percentage of their pretax salaries to investment accounts that grow tax-deferred. Many employers match a portion of workers’ contributions.

If you leave your employer, how you deal with that nest egg may be one of the most important financial decisions you’ll ever make, experts say.

Here’s a look at the options you have with 401(k) funds if you’re laid off or leave your job voluntarily:

Question: If I just want the cash, I can have it, right?

Answer: Yes. In fact, about 68% of 401(k) participants opt for cash payment of retirement funds when changing jobs, according to the consulting and record-keeping firm Hewitt Associates, which studied 170,000 account payouts to workers ages 20 to 59 in 1999.

About 26% of workers rolled their balances into individual retirement accounts, Hewitt found. Only 6% moved their money to a new employer’s 401(k) plan.

Younger investors and those with smaller accounts are the most likely to take cash: 78% of twentysomethings, for instance, took the money out, Hewitt found.

Older and wealthier workers were more likely to roll the money into a new retirement account. Fewer than 10% of those with balances above $100,000 took the cash, for example.

“If you need [the money] to buy food, that’s one thing,” Slott said. “Perhaps you have no choice. But there’s a big difference between a want and a need. A lot of people say, ‘I really need a new big TV.’ ”

Question: Why do financial advisors suggest rolling the money into another retirement account rather than taking a cash distribution?

Answer: Two main reasons: First, even people who say they will still set the cash aside for retirement savings may not do so, and may spend the money instead.

Keeping a nest egg in a qualified retirement plan such as a 401(k) or IRA has more than tax advantages: If you run into serious financial trouble, assets in retirement accounts are protected from creditors--whereas savings outside those accounts would be fair game.

Second, the tax bite to cash out can be very painful. Investors under age 59 1/2 must pay a 10% penalty on money withdrawn from tax-deferred retirement accounts. In addition, you will owe taxes at your ordinary income rate on cash you take out.

An investor in the 31% federal tax bracket, for instance, would lose $8,200 on a $20,000 withdrawal--a penalty of $2,000 and taxes of $6,200.

Question: If I want to do a rollover of my 401(k) balance, should I put the money into an IRA or into my new employer’s 401(k), if one is offered?

Answer: That depends. Some financial advisors, including Slott, note that an IRA rollover would allow you to put the money into whichever investments you choose--individual stocks, mutual funds, etc.

The typical 401(k), by contrast, offers only 10 to 15 investment selections.

But 401(k)s can be more cost-efficient: Investors often have access to low-cost mutual funds that are off-limits to most IRA savers and other retail investors; employers may subsidize the 401(k) plan’s administrative expenses; and there is no set-up charge, as there is with many IRAs, depending on the brokerage or fund company you use.

Question: Can I roll my 401(k) balance into a Roth IRA, which would allow tax-free distributions in retirement?

Answer: No. You would have to put it into a regular IRA and then convert it to a Roth.

It may be worth looking into, some experts say. A Roth conversion triggers tax liability in the current year on the full amount converted. But the trade-off of paying taxes now in exchange for tax-free distributions in retirement could make sense for some investors.

It makes the most sense to do such a switch when the stock market--and thus the value of your account, if heavily invested in stocks--is off its peak, as it may now be, said Mark Luscombe, principal analyst at CCH Inc., a publisher of tax information based in Riverwoods, Ill.

Just be sure you meet the income requirement for a Roth conversion: You must earn less than $100,000 a year (for both single and married investors).

Question: Should I do a direct rollover into another retirement account, or take the money in my name first and then roll it over?

Answer: Specifying a direct, or trustee-to-trustee, transfer, is simpler and less risky than taking the money in your name and then having to worry about the IRS’ 60-day rule, advisors say. That rule says you must have the money in the new account within 60 days, or it will be considered a taxable distribution.

If you take the money in your name, even with the intention of rolling it into another qualified retirement plan within 60 days, the current plan trustee will withhold 20% for federal taxes. That forces you to make up that amount within the 60 days in order to fund a full rollover and eventually get back the money withheld.

For a direct transfer, you must have an IRA set up first or make certain your new employer will accept a rollover into its 401(k). Most major employers will accommodate rollovers, though some firms have a waiting period of one to 12 months.

Even a two-step rollover, in which you get your hands on the money first, is likely to go more smoothly if your new account is set up before you shift the funds, Luscombe said.

Question: Can I just leave the money in my old employer’s 401(k) plan?

Answer: Yes, as long as the balance is at least $5,000, said James Delaplane, a vice president at the American Benefits Council, a trade group that represents large employers. If your account is smaller than $5,000, your former employer may boot you out of the plan because of administrative costs.

Though most workers prefer to take their account with them, in one form or another, advisors say there may be cases where one’s former employer simply has a vastly superior 401(k) plan. You should consider such factors as administrative costs as well as investment options.

Of course, once you leave an employer, neither you nor the employer will be making new contributions to that account, though the money will continue to grow tax-deferred.

Question: Is a partial 401(k) rollover allowed?

Answer: Yes, in most cases. You would be subject to tax and penalty on the amount taken in cash.

Question: If part of my 401(k) is in company stock can I take shares rather than cash for that portion?

Answer: Yes. There may even be tax advantages to such a strategy, Luscombe said, “but the considerations are very tricky” and you should first consult a professional advisor, he said.

If the stock is privately held rather than publicly traded, you may also need to consider how liquid the shares are, he added.

Question: Would the pension reform bill now in Congress affect rollovers?

Answer: Yes. The bill, which gradually would increase 401(k) and IRA contribution limits over the next few years, also would make pension plans far more portable across employment sectors.

Currently, workers in 403(b) and 457 plans, which are designated for public-sector employees, are unable to roll their assets into a 401(k), and vice versa. Thus, a state hospital nurse who goes to work for a private clinic, or a state teacher who joins an educational publishing firm, must keep assets in their old plan.

Those barriers would be eliminated, Delaplane said.

Rolling into an IRA would also be easier, he said. Currently, 403(b) investors cannot roll their assets into an IRA if they have rolled any 401(k) money into that IRA in the past. Under the pension reform bill, such mixing would be allowed.

Investors in 457 plans now are prohibited from rolling those assets into an IRA under any circumstances, Delaplane said, but the reform bill would lift that rule.

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To Roll Over--or Not?

About 68% of 401(k) plan participants opt for cash payments when leaving their jobs instead of rolling the balance into another tax-deferred vehicle, a study found. Younger workers are most likely to take a cash distribution, according to the survey of 170,000 distributions during 1999.

Age 20-29

Lump-sum cash distribution: 78%

Rollover into IRA: 15%

Rollover into 401(k): 7%

Age 30-39

Lump-sum cash distribution: 66%

Rollover into IRA: 27%

Rollover into 401(k): 7%

Age 40-49

Lump-sum cash distribution: 61%

Rollover into IRA: 33%

Rollover into 401(k): 6%

Age 50-59

Lump-sum cash distribution: 60%

Rollover into IRA: 36%

Rollover into 401(k): 4%

Source: Hewitt Associates