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The cost of taking retirement money early


Dear Tax Talk,
My plant is closing for good and I am going to roll over my company 401(k) into an IRA as soon as my company notifies me of my separation date. The scenario is this: The IRA is at my credit union and the rollover transaction is successful at my credit union on Sept. 1, 2004. How quick can I get my money when I tell my credit union on Sept. 2, 2004, that I want to cash the IRA out? Also, what are the penalties for cashing in my IRA at this point? I know I avoided the 20 percent right off the top by not cashing it in from my company and taking the money directly. I was told to roll over my 401(k) into an IRA first and then cash it there to avoid more severe penalties. Is this correct? This will involve a six-figure amount. Thanks.

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Dear Ray,
There are a lot of complications in your situation, as well as opportunities for planning, especially since the IRA is in the six figures. You definitely don't want to make a costly mistake that cuts into your life savings.

It's true that if you take a direct payment from the 401(k) plan, you'll be subject to 20 percent withholding. You need to determine whether you really do need all that money at once.

If you put it into the IRA, you might avoid part of the withholding, but the bank might withhold 10 percent if you're under age 59½. The 10 percent represents the penalty for early withdrawal that wouldn't apply to the 401(k) distribution if you're age 55 or over when you leave the plant.

Since you're unemployed, you may avoid part of the penalty if you incur medical insurance costs and the money is in an IRA. The remainder of the withdrawal is taxed at ordinary income tax rates, which can be as high as 35 percent, depending on your other income.

Your best opportunity for planning depends on what you'll do when you're laid off. If you're thinking of starting your own business, then you might be able to take advantage of the 401(k) money to help you start that business and not pay any taxes on the money.

Let's say your dream is to open your own business and you need $20,000 to get started and that money is in your retirement plan. What you can do is start your own retirement plan for your new business and roll over your 401(k) to that plan. The plan that you establish will permit participants, namely you, to borrow funds from their vested balances. You can borrow up to $50,000 or half of your vested balance and not pay tax on the borrowings.

In addition, you can defer making contributions into the plan until the business has profit. While the setup costs of this idea may run $1,000 in professional fees and costs, it's certainly cheaper than the tax penalty you may owe.

-- Posted: Dec. 17, 2003




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