Unemployed? How to Cash Out Your Retirement the Less Painful Way

Quickly, many laid off workers will look to their retirement savings as a source of financial salvation.ABC News Photo Illustration
Quickly, many laid off workers will look to their retirement savings as a source of financial salvation.

Lose your job, and you will face tough financial decisions indeed.

Quickly, many laid off workers will look to their retirement savings as a source of financial salvation. That's quite understandable given that for many of us it's the largest single pot of money we own.

Yet there are consequences to drawing from retirement accounts during a spell of unemployment as I outline for the reader below.

Q: I recently was laid off and I have about $11,000 in a 401(k) fund at that company. What are my options at this point? I know that there are penalties and fees associated with withdrawing the money before retirement age, but what if I need the money to make a house or car payment? -- S.L., Houston

VIDEO: GMA financial contributor Mellody Hobson gives tips on retirement savings.Play

A: S.L., as you suspect, your options do include drawing upon your 401(k) funds to help pay living expenses while unemployed, but it's not as simple as you might think and you will pay a heavy price for doing so.

In an ideal world, it would be best if you could leave untouched your accumulated retirement savings while you cope with unemployment. It will be difficult to make up for the lost ground, and the cost is much higher than you may realize.

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I know in this economy that ideal may seem unrealistic for many, particularly those who experience long periods of unemployment.

But even if forced to make a bad choice, there are steps you can take to mitigate the damage if you understand some of the rules surrounding retirement savings accounts.

First, let me suggest one thing you absolutely should not do, and that is cash in your entire 401(k) account all at once.

As you may know, cashing in your 401(k) account will trigger a 10 percent penalty, assuming you are years away from retirement. Plus, you will owe ordinary state and federal income taxes on the withdrawal, which could easily take another 30 percent bite out of your retirement savings.

That means your $11,000 could quickly turn into $6,600 or maybe even less depending upon your tax bracket and the state you live in. So that $11,000 is not going to get you as far as you think.

Easier Withdrawals From an IRA

Even if you decide you have no choice but to draw down retirement savings, it's best to draw down those funds a little bit at a time, rather than all at once.

In most cases, laid off workers are better off transferring their 401(k) account from a former employer's plan into an IRA that they control. Generally, you have more flexibility with an IRA than you do with a 401(k), particularly once you've left a job.

There are similarities in the ways 401(k) plans and IRAs operate such as the 10 percent penalty on early withdrawals before age 59½ and the need to begin making required minimum distributions after reaching age 70½.

But withdrawing funds from an IRA before retirement is usually easier than from a 401(k).

For instance, with an IRA, penalty-free early withdrawals are allowed in limited circumstances, such as for a disability, a first-time home purchase, college expenses or paying for health insurance premiums while unemployed. These exceptions are not available with a 401(k) account.

The health-insurance exception, in particular, may be helpful in your case, S.L. Just be aware that you qualify only after collecting unemployment benefits for 12 consecutive weeks. And even though the 10 percent penalty is waived, you would still owe ordinary federal and state income taxes.

One reason to stick with the 401(k) plan is if you are 55 or over, or will turn 55 this year.

In most cases, 401(k) account owners can make penalty-free withdrawals only after turning 59½. However, IRS regulations allow 401(k) account owners to make withdrawals without the 10 percent penalty if they leave the employer that sponsors the plan in the year they turn 55 or later.

But remember, you'd still owe ordinary income taxes.

You do not have this option with an IRA. So for laid off workers at or around age 55, I'd probably stick with the 401(k) plan until your financial situation becomes stable.

One issue younger laid-off workers should consider before moving assets from a former employer's 401(k) plan is whether they have any outstanding loans taken from that plan. In most cases, companies require employees to pay off 401(k) loans upon leaving, whether they leave by choice or by layoff.

Hardship Withdrawals Still Trigger Penalty

But some 401(k) plans do allow former employees to continue making installment payments even after leaving a company. For a laid off worker, this can provide flexibility at a time of financial need. Check to see if your 401(k) plan has such a provision before deciding whether to move your assets to an IRA.

One reason not to keep retirement savings in a former employer's 401(k) plan are the hardship withdrawal rules that allow for distributions in narrow circumstances such as unreimbursed medical expenses, college expenses and payments to prevent foreclosure or eviction. However, even in these circumstances, the 10 percent early withdrawal penalty still applies.

As you can see, S.L., the many rules that surround 401(k) accounts and IRAs can be quite confusing. Before you make a snap decision, I'd suggest you learn more about these to keep from making a bad situation worse.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.