Don't Cash Out

  • Share
  • Read Later
Maha Hermes spends a lot of time thinking about her future these days. A casualty of another dotcom debacle, the 33-year-old event planner lost her job last month. She was disappointed, of course, and worried about when she would find another position. But among her first concerns was figuring out what to do with her retirement savings. She has plenty of company: more than 400,000 workers have been fired since the beginning of January, and the layoffs keep piling up.

If you're one of them--and concerned about where your next paycheck will come from--you may be tempted to cash out of your former employer's 401(k) plan. But most financial experts agree: Don't take the money and run, if at all possible.

Remember, that money is growing tax-deferred. Even a $5,000 nest egg could mushroom into more than $50,000 in 30 years (based on an 8% annual growth rate), according to benefit consultants at Hewitt Associates. If you decide to take the $5,000, you may be surprised when you get a check for just $2,850. That's all that would be left, assuming a 28% federal tax, 5% state tax and 10% early-withdrawal penalty. If you have at least $5,000, you can leave the money in your employer's plan until you decide what to do. And you can usually transfer the funds to another company's 401(k) once you land that new job. But most displaced workers would rather just cut the cord with their former employer.

That's why Stephen Butler, author of 401(K) Today, suggests that people like Hermes roll over 401(k) money directly into an individual retirement account, which your ex-employer can do. Don't take that check. Have it sent directly to the financial institution that you've chosen to hold your IRA. "If you take the money, your employer will withhold 20%," says Butler. "That's $1,000 out of, say, $5,000. Then you have to come up with the $1,000--the missing 20%--out of your own pocket so the amount deposited into the new IRA is exactly the same as the amount of your distribution. You'll get it back after you file your taxes, but it's crazy to put yourself in that situation." Not to mention that if you take the money from the 401(k) before turning 59 1/2, you will be subject to a 10% early-withdrawal penalty, plus you'll be taxed at your highest marginal rate.

New York-based financial planner Melissa Levine says an IRA also gives you more flexibility. Instead of picking from a handful of mutual funds, an IRA offers infinite choices: stocks, bonds and funds. There are drawbacks: you can't borrow against your savings, as you can with a 401(k). But if you lose your job, you'll have to pay back any loans against your 401(k) anyway. If you don't, the loan amount is usually treated as an early distribution--that 10% penalty again.

Other benefits of IRAs: you can withdraw funds from an IRA for a first home or higher education expenses without paying an early-withdrawal penalty. And in some cases, you may be able to convert the IRA into a Roth IRA, which allows your assets to grow tax-free.

Hermes didn't have a choice about leaving her job, but she can choose how to invest the retirement dollars she saved. She hopes to retire early, on her own terms, but until then she's playing it smart, planning wisely for the future.

Sharon Epperson is a correspondent at CNBC Business News. E-mail her at