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Answer:
Dear
BuyandHolder,
Well,
I advise you to think over your "taking the cash"
decision very carefully and discuss it with your accountant.
Rarely is it the best decision. And you do have several
other options. They are:
1)
Doing nothing. Most 401(k) plans allow departing
employees to leave their money where it is and where
it will continue to grow on a tax-free basis. This
is a good solution if the plan is well managed.
2)
Transferring the money. If you move on to a new
job and if your new company offers a 401(k) plan and
if the new plan accepts transfers, then you can roll
over your money into the new plan, with no tax consequences.
Again, this means your money will grow tax-free.
3)
Setting up a rollover. You can roll over the money
into an IRA. We discussed this in a recent column;
click HERE
to read.
4)
And finally, you can take the cash value of
your account.
The
pitfalls of option #4
You
didn't mention your financial situation -- perhaps
you are thinking of using the cash to pay off your
mortgage, meet a college tuition bill or splurge on
a Jaguar. But if you go this route, you'll be facing
some serious financial and tax hurdles.
If
you take the money, that is, accept a check, and you
do not roll over your money to an IRA -- or transfer
it to a new employer's 401(k) plan -- within 60 days
of actually receiving the check, your old employer
by law must withhold a full 20%. There's no way around
this. The money is used to prepay federal taxes.
So
even if you put it in a savings account, Treasuries
or a bank CD with a decent yield, you'll still wind
up with less money. On top of that, you will also
owe state and possibly local taxes on your cash distribution.
More
bad news... The IRS regards this type of payout as
an early distribution if you are under age 59 1/2.
When that's the case, you will be hit with a 10% early
withdrawal penalty on top of combined federal, state
and local taxes.
A
final point to bear in mind if you take the cash --
you will continue to owe taxes each and every year
on any future earnings money earns outside the protection
of a 401(k) or an IRA.
So
I cannot support your idea of simply taking the money
out of your plan.
Consider
borrowing against your 401(k)
If
you need a sum of money for a serious purpose, borrowing
from your 401(k) is a better (although not a perfect)
solution than cashing out. Most 401(k) plans allow
participants to take loans. Federal law puts a cap
on the amount you can borrow -- half the amount you
have vested in the plan or $50,000 -- whichever is
less. Some plans, but not all, have a minimum amount
that you must borrow. Federal law also requires that
you pay interest on the loan. However, you are paying
yourself back -- a slight benefit over paying interest
to a bank.
The
majority of 401(k) plans require that participants
to pay back the loan within five years. An exception:
if you use the money to buy a primary residence, you
can generally take out a 25-year loan.
A
heads up if you're married
Your
401(k) plan may require your spouse to agree to any
loans in writing. That's because spouses typically
have a legal right to a portion of their husband or
wife's retirement plan should there be a divorce.
For
More Help
The
portability rules pertaining to 401(k) plans are complex
and I've merely outlined the overall conditions. Before
you make a final decision, you should read the information
at: www.401khelpcenter.com
(click on the "Plan Participation Channel"). The pros
and cons of taking out a loan are explored in detail
here as well as other issues.
You'll
find excellent calculators at: www.why401k.com.
Take time to run your numbers.
Good
luck!
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