GETTING PERSONAL: What To Do With Your 401(k) After A Layoff

NEW YORK --Taking care with a 401(k) plan after being laid off by your employer may prevent easy-to-make mistakes that can cut sharply into life savings.

Many people run up big, unnecessary tax bills on 401(k) money after job losses; others forfeit thousands of dollars in potential investment returns. Widespread job cuts now under way make this a likely time for missteps.

Consider the financial strength of the 401(k) sponsor in this harsh economy before deciding what to do with the plan. Other things to look at are the quality of the plan, and whether it holds company stock.

Even financial advisors are not immune to 401(k) errors; a surprising number lose money for clients by mishandling their plans after a job change.

"Some of the biggest mistakes I see are made right under the nose of advisors and with their consent," said Ed Slott, an IRA expert whose latest book is "Your Complete Retirement Planning Road Map."

Four routes are open for the 401(k) participant after a layoff: leaving the money where it is, cashing it out, or rolling it over into an individual retirement account or a new employer's plan.

   In Bad Economy, Consider Employer's Health 

Hard times create potential drawbacks to sticking with the old 401(k). Many companies are struggling, making it harder to know whether complications could arise.

Holly Isdale, managing director at Barclays Wealth, a unit of Barclays PLC (BCS), says it can be difficult to deal with a 401(k) plan if the old employer is purchased by another company. Just figuring out whom to call for help may confuse some people.

"Even the most solid-looking companies may turn out to be on the brink of disaster," said Slott, who advises recently terminated employees not to trust their 401(k)s to the former employer.

Leaving money in the plan after losing your job can lead to an untended account balance reviewed only when statements are sent. That scenario is potentially disastrous right now. John Nersesian, managing director of wealth management at Nuveen Investments, says the practice of "'set it and forget it' will not work in this environment."

Money in a 401(k) plan is protected under the Employee Retirement Income Security Act of 1974, or ERISA, and former employees will get their retirement money even if the company goes bankrupt (unless all the money is in company stock that becomes worthless, as was the case with Enron Corp).

Nonetheless, corporate changes can cause trouble for a period of time.

"When a company begins to get into problems, if you have money in the stock of the company, you could lose the ability to sell those shares for a while," said Dallas Salisbury, president and CEO of the Employee Benefit Research Institute, a nonprofit employee benefits research organization in Washington.

Still, it can make sense to leave the 401(k) money with the old company if the plan has good investment options and competitive fees. If it offers helpful information through a Web site and advisors who give independent advice, so much the better.

   Tax Error To Cash Out 

As for cashing out a 401(k) plan, the option may be tempting, especially if one is unemployed and cash-hungry. The move is a tax disaster, however, and goes against one of the main purposes of having a 401(k).

Taking money out before age 59 1/2 (age 55 if separated from service at that age or older) triggers federal income tax at ordinary income rates, a 10% federal penalty, and state penalties in some cases. State and local income tax may also apply, depending on where you live.

The Schwab Center for Financial Research uses the example of a hypothetical 401(k) worth $56,000 to show the perils of early withdrawal. A federal penalty of $5,600 plus, say, 28% in federal income tax are triggered by taking out the money early. The $56,000 shrinks to $34,720, not including state and local taxes the person may owe.

The cost of lost investment opportunity could be huge, Schwab notes. The $56,000 left to grow at a hypothetical 8% annual rate of return would amount to roughly $563,000 some 30 years from now.

Withdrawing even a portion of the money, say $5,000, is also a bad idea. The participant pays a $500 penalty plus $1,400 in federal tax (assuming a 28% bracket), leaving just $3,100, and with state and local taxes possibly still left to pay. That $5,000, growing tax-deferred at the hypothetical 8% for 30 years, could become $50,300 in retirement money, Schwab notes.

   Benefits of Rolling Over 

Rolling over a 401(k) into an IRA is one way to keep money growing tax-deferred while you remain flexible and in control. IRAs allow one to invest in a range of products, including mutual funds, stocks and bonds.

Rollovers also help reduce the clutter that can result after a few job changes leave one with several 401(k) plans.

A big hitch for those rolling over into an IRA, though, is the 60-day window that begins when the distribution from the 401(k) is made. Missing the deadline triggers ordinary income tax on the full amount of the distribution.

Though it may seem like a no-brainer to get money out of the plan and into an IRA within 60 days, the deadline poses a problem for many people.

"This is the biggest challenge in rollovers," said Salisbury. "Historically, people take out the amount and forget to roll it over; they then get a 1099 [form] at the end of the year from former employer saying, 'You now have to pay taxes.'"

A direct rollover, also known as a trustee-to-trustee transfer, is a good way to avoid missing the deadline, according to Kaye Thomas, who publishes the tax advice Web site www.fairmark.com.

A special tax break makes it imperative that you review company stock in your plan. Tax rules known as net unrealized appreciation, or NUA, give favorable treatment to some appreciated company stock. To qualify, the taxpayer must have left the company, reached age 59 1/2, died or become disabled.

Then, he must take all of the funds out of the 401(k) plan within one calendar year and put the company stock into a taxable account. Ordinary income tax is due on the cost basis of the company stock (the amount paid for it). Ordinary income tax is also due on the rest of the 401(k) plan funds (the non-company stock), unless they are rolled over to an IRA within 60 days of the distribution.

When the stock is eventually sold, the untaxed gain (the NUA) is taxed at long-term capital gains rates. Any further appreciation is taxed as short-term capital gain unless the stock has been held outside the plan for more than a year, when it is taxed as long-term gain.

(Arden Dale is a Getting Personal columnist who writes about personal finance; she covers topics including tax and estate planning, retirement, investment strategies, and financial needs of small businesses. She can be reached at 201-938-2052 or by email at arden.dale@dowjones.com.)

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