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

Moving 401(k) savings to an IRA before cashing out could soften the blow.

ByABC News
March 16, 2009, 6:08 PM

July 7, 2009 — -- 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

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.

Looking for financial advice? Click here to send David your questions and they might end up as a topic for his next column.

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.