What Should You Do With Your 401k When You Get Laid Off

By Pinyo, on January 12, 2009

It’s tough losing your job. Unfortunately, it’s that much more possible in this economic recession. There are many things to do when you get laid off; one of them is deciding what to do with your 401k. When you are laid off, you have the choice of leaving the 401k funds in your current plan, cashing out the plan or rolling the funds over into another qualified retirement account. Your employer will likely give you a packet with all of the necessary information to properly manage your options.

First, find out if you are fully vested. You are always entitled to the money you contributed, but how much of the employer matching contributions you’re entitled to depend on your tenure. If you worked there for a few years, chances are you’re 100% vested. Now, explore these options below:

1. Leaving Money In Your Old 401k Account

This sounds simple, but unless your old plan is that extraordinary, it’s probably best not to use this option. First, your former employer probably doesn’t want to deal with the hassles and expenses of administering your account, and may pass the expenses on to you. Second, you may find it more difficult to get help when you need one. Third, you will not be able to borrow against your 401k balances, which is not necessarily a bad thing, but it does leave you with less flexibility (here’s an article that discusses why borrowing from 401k is bad). Last, this will be one additional account that you’ll have to track and manage.

Also note that if your balance is below certain threshold and you do nothing, your employer may close your account and send you a check, which will put you in a situation similar to the Cashing Out option below. Try to avoid this, since it will give you much less time to react.

2. Cashing Out

If you cash out without designating a qualified retirement account, such as a 401k or an IRA, the employer is required to withhold and send 20% of the money to the IRS. If you do not deposit into a qualified retirement account within 60 days, you will also be subject to taxes, and if you are under age 59½, a 10% early withdrawal penalty.

To avoid these taxes and penalties, you have 60 days to deposit the money into a qualified retirement plan, but you will have to come up with the 20% withheld to make your old balance whole again. You can recover the withheld amount when you file your tax return.

3. Rolling The Money Over Into A Qualified Retirement Account

There are two ways to roll over your 401k: direct and indirect. If you do a direct rollover, there are no taxes, withholding, or penalties. A check is sent directly from your current 401k plan to the designated retirement account — i.e., your new employer’s 401k or your IRA. Although the option of rolling over to another 401k may not be available, unless you find another job right away.

If you do an indirect rollover, a check will come to you but minus 20% that’s required to be withheld by the employer and send to the IRS. For example, if your balance is $100,000, your employer will send you $80,000. To complete the rollover, you have to send a check within 60 days to your new IRA custodian for $100,000 to match the exact original amount. Any amount under $100,000 deposited into your new retirement account will result in taxes and a 10% early withdrawal penalty if you are under age 59½. The extra $20,000 that the IRS is holding will be returned to you when you file your tax return.

Conclusion

Out of the options, I recommend direct rollover into an IRA the most. This will ensure that you avoid all the taxes and penalties, and you don’t have to come up with the 20% difference as per the indirect option. Additionally, having the money in an IRA account offers you a much wider variety of investment options — which may better help you achieve your asset allocation objectives and financial goals.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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23 Comments

Abigail
January 12, 2009, 12:04

You mention a penalty, but to be more specific, you have to pay 10% for early retirement withdrawal. That isn’t a big deal if you’re just starting out and only have a few hundred in the bank.

But if you’ve been contributing awhile, that’s a considerable ding, especially if you don’t make that payment immediately after getting the funds. (Money has a way of disappearing and that 10% that you swore you’d leave in the bank may just disappear.)

I guess I’m wondering why you suggest rolling into an IRA. If your 401(k) is doing okay in your old employer’s account and you are hoping to get another job, why not just leave it there? Once you make something into an IRA, it’s my impression you can’t turn it back to a 401(k) again. So if you do get a job at a new place, you have to start your 401(k) from scratch.

Of course, if your 401(k) is being poorly managed, you would want to go elsewhere. But it seems like the easiest and smartest thing to do would be to just hang on and see what the job situation pans out to be.
Kyle
January 12, 2009, 12:41

I rolled my 401k into a rollover IRA. I’ll probably end up converting it to a ROTH at some point this year.
Pinyo
January 12, 2009, 15:11

@Abigail — I mentioned 10% twice! As for rolling your money into an IRA, that’s usually the preferred choice because you’ll have access to a lot more investment options. This is especially advantageous if your current plan offers sub-par selections.

As for rolling over into a 401k, this is probably not the best option for someone who got laid off since they will probably take more than 60 days to find a good job with 401k in this economy.

@Kyle — I think Roth is a good option for some, but if you have substantial amount of money already in 401k, converting that to a Roth could result in a huge and unaffordable tax bill.
Everyday Finance
January 12, 2009, 16:30

I’ve known several people who have either left their employer or been laid off and they took the cash. Bad idea in my opinion. I think they felt entitled or had an excuse to take money from the account and indulge a bit, but the reality is that they just took a nest egg they spent years building and then during a career transition, depleted a significant portion of it and started over. If they move a few times during a career, that’s a lost opportunity of a few hundred thousand dollars in retirement (present value assuming market moves up from here over 20 more years). I recently posted on 401K asset allocation which showed some disturbing trends as well regarding % held in company stock.

I think you rendered some good advice here.
Craig
January 12, 2009, 17:54

Very informative post and very useful for me. That happened to me and I am looking into how to directly rollover my previous simple IRA account into a traditional IRA account.
Travis
January 13, 2009, 15:26

Really good post for this economy. A lot of people are getting laid off right now, and I may be next as our work has drastically slowed down. Its nice to know what do with my 401k if that happens. Thanks for the advice. Hopefully that doesn’t happen, but its best to be prepared just in case.
Kenny G
January 14, 2009, 21:44

401k? i get laid off now.. . luckily, i have more than 401k at this time. thanks for post, it’s really make sense to me at this time.
poor boomer
January 14, 2009, 23:29

What should you do when you’re laid off if you don’t have a 401(k)?
waggore
January 25, 2009, 23:09

I may have a really stupid question, but I’m very new at this: Does it matter that the economy is in a slump right now — and you may want to wait to roll over your 401K into an IRA until the market perks up a little to make sure to not “lose” your money? And one more question: Am I correct in understanding you can’t roll your 401K over into a Roth IRA because the amount of money is usually too high to do so?
Pinyo
January 26, 2009, 9:07

@Waggore – There’s no stupid question First, in order to rollover your 401k, you’ll have to leave your current employer. Otherwise, the transition shouldn’t make a difference where the stock market is, because for the most part both 401k and IRA are meant to invest in the stock market. So you are really selling stocks to buy stocks.

As far as Roth. You cannot rollover 401k directly into Roth IRA. However, you can rollover your 401k into a traditional IRA, then later convert that into a Roth IRA. However, many people do not follow this route because you’ll have to pay taxes on the conversion, which could be very expensive.
Kelly Johnson
January 30, 2009, 10:59

Beginning Jan 1 2008 you can actually roll your 401k directly to a Roth IRA. Of course this still could get very expensive if you have a lot of money in the 401k. One still may want to rollover to a Traditional IRA and then convert the entire account to a Roth in different years to break up the tax liability.
Pinyo
February 1, 2009, 19:06

@Kelly – Thank you for the correction. I didn’t realize that and just confirm what you said is true. Thank you.
pez
February 11, 2009, 21:50

I have a question regarding my 401k. I got laid off and i told them i did not want to take the money out and they said ok. But behold they sent me a check of the 401k with federal taxes already taken out. I went through turbo tax and they said i am having to pay an additional 10% of my 401k which is really stupid because i got laid off instead of just taking the money. Does the 10% rule still apply to me? By the way i did not do anything special with the money i just cashed it and spent it “wasnt a butt load of money which is why i spent it”.
Pinyo
February 11, 2009, 21:56

@Pez – I am sorry to hear about your situation and your HR/401k plan administrator could have handled it much better. If you are still within the 60 days window, you could open a Traditional IRA and avoid the 10% penalty. However, you’ll have to deposit the full original amount before taxes were taken out. If you are outside of the 60 days windows, you’ll have to pay the 10% early withdrawal penalty…unfortunately.
Chelseamomof5
March 7, 2009, 20:57

My husband got laid off and his employer is also terminating the 401k plans. We have 5 children at home and a mortgage of $1500 a month. We only have about 40k left in the 401k. He is in construction, which has come to a screeching halt. I drive a school bus and carry the med. insurance, so I am afraid to leave that security for a job which I would be lowest on the totem pole. I think we should just pull it out and put it where we can get to it for immediate bills. We have a small savings, but only enough for 2 to 3 months and if the work doesn’t pick up, we will be in trouble. We are getting the house ready for market, but since he’s laid off, if we were to sell(not easy in this market) I don’t know if we would be able to buy something else. If we had the 401K less taxes and penalties, I feel it would help us float til the construction pulls up. I think with my salary and him picking up side work, we could make the other bills and food and gas. What do you think?
Pinyo
March 9, 2009, 12:13

@ChelseaMomOf5 – I am sorry to hear that.

I believe you can roll your 401k into a Roth IRA (you’ll have to pay taxes on the amount). And Roth IRA has a provision that allows you to withdraw the principal without paying the 10% early withdrawal penalty.

Please check with your financial planner to make sure this is correct.
Steve
June 20, 2009, 17:21

Ok, I know you said there are no dumb questions but how about this one.

My wife gets laid off and we asked about leaving the 401K with the former employers plan which she can do but now we are having second thoughts. The loot is fully invested in bonds and mutual funds and my question is. If she was to roll it over into an IRA does the plan company have to sell the funds and give her a cash check or can you just have a transfer of the funds?

The reason I ask is because a couple of the funds had front load (5.75%) fees and I would assume that she had that amount lopped off her original contributions which over 15 years have been considerable. Of course the next question is if she does have to take the cash then I guess it would be best to wait until the market improves a bit?

Thanks. Steve
Pinyo
June 21, 2009, 11:18

Steve, I’m not sure what the correct answer is, but I am leaning heavily toward a NO answer because 401k plan often has access to different funds than individuals do and you may not be able to own your current funds inside your IRA account. The best person to ask is probably your wife’s 401k plan administrator.

As for timing the market, it’s not necessary. You are selling out of the stock market and into the market in relatively short time and would have not significant impact except for the trading expenses.

If you want additional answers, you may want to try Moolanomy Answers.
Steve
June 21, 2009, 13:03

Ok thanks Pinyo,

I thought that might be the answer as just about everywhere there are comments about rolling into an IRA it talks as though its cash although no one specifically says that.

I get your point about it not really being an issue cashing out and then repurchasing, it wouldn’t make much difference.

I know this is not a forum for mutual funds but I thought it ironic that the front end load fund has the highest fee ratio and has done the worst YTD of any…………………..isn’t that always the way!

Steve.
Trenton Dennis
August 24, 2009, 0:54

All this sounds good, but I was laid off in april 09. Haven’t found a job yet and not even gotten an interview. I worked in HR in staffing (go figure). My money runs out in October. Unemployment is only 1900.00 a month. My mortgage is 1913.00 a month. No job in sight. My 401k has defaulted and I am going tomorrow to find a financial analyst.

Fortunately I don’t have any credit card debt but have a 590.00 car payment. I am trying to sell the car but the loan is 26k and I can only get 16k for the car. I need to come up with the difference to get rid of the monthly payment. I may be able to make it without the car payment. I worked for more than 15 years at my company and RPO is there motto now.

Can I roll the 401k over into an IRA and get the difference to pay off the car? If not then the car is repossessed and my credit, which took me 7 years to get built back up is ruined and no loans can ever come my way. Now I am not an over spender. My last car had 235,000 miles on it and broke last Feb ‘08 so I had to get another car. I was making 90k yr so I was not one of those who was speculative. I also don’t have a second mortgage. I just don’t have a job and can’t get a loan. ING is my 401k company.
Nathan
August 26, 2009, 1:59

Let’s say I get laid off and rollover my 401k into IRA. After I find a new job, can I rollover my IRA into my new job’s 401k?

Thank You
Bryon Severns
December 4, 2009, 16:06

To Chelseamomof5:
I am running for Congress and I would like to use your story to illustrate the pain felt by millions of Americans who have been laid off and need to spend their savings in 401k. Making you pay 10% penalty in your time of need really is kicking you when you are down. This is an unjust tax and I am trying to fight it, but I need real life stories to convince people to repeal this tax. If we succeed then maybe you can get a refund of that 10% penalty. Please reply to me at bryonss@yahoo.com, Bryon Severns, Arlington, Libertarian Party of Texas.
CanesFan
December 19, 2009, 2:08

Hello- My wife has two (401k)s with two former employers both plans are just sitting there. She is now a stay at home mom and with our family growing we have decided to add 2 bedrooms to our home.
My question is… Can we cash out one of the 401k’s for the addition on our home without a penalty? or can I borrow against it even though she is no longer working there?

Based on what I’ve read neither of these are an option which leads me to one more question.
If I roll over both 401k plans into a traditional IRA, can I then borrow against that? or is there a time frame of how long you must have an IRA before you can do that?

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