I have just been laid off. Can I use my 401(k) for living expenses now and report it as income next year?
If you have been laid off, depending on the plan document (Summary Plan Description / SPD that you should get each year) describes how you can access your funds for hardships (taxable) distributions and possible plan loans (non-taxable if you repay the loan). These distributions are subject to taxes (and you have a 20% mandatory withholding. Also, if you were under age 55, you will pay a 10% penalty on most 401k plan distributions (note that the age is less than the 59 1/2 for IRAs). For a loan, you must pay it back per a schedule.
For the most flexibility, especially if you are over age 59 1/2 (so you can avoid the 10% penalty), you should roll it into an IRA at your preferred brokerage house (I typically recommend Charles Schwab or Fidelity to clients). Once it is in an IRA you have complete flexibility to take distributions for living expenses. There is also NO mandatory withholding on IRA distributions, but if you pay no taxes until the next April 15th, you could have under-payment penalties.
- If you are between ages 55 and 59 1/2, try to keep it in the 401k to avoid the 10% penalty.
- If you are above age 59 1/2 (and have no availability for 401k plan loans), roll it into an IRA for more flexibility.
- If you are under age 55, then roll it into an IRA for more flexibility.
- Note: If you have employer stock in the plan, make sure to look into NUA (Net Unrealized Apprecation) rules as there may be opportunities there.
If you have any more issues related to your layoff you need help with, check out my Layoff Survival Guide.
I am sorry that you have been laid off. You could take early distributions from your 401(k) to cover living expenses. The distributions will be taxable in the year that you have taken them as income. In addition, you will owe an early withdrawal penalty of 10%.
Any amounts withdrawn from your 401(k) plan must be treated as ordinary income for the year the amount is distributed from your 401(k) account. Consider the following:
- If any portion of the withdrawal is rollover eligible, the plan administrator must withhold 20% for federal taxes if the amount is paid to you instead of being processed as a direct rollover. State tax withholding may also apply.
- If you want to avoid the mandatory federal (and if applicable, state) tax withholding, you should have the amount processed as a direct rollover to a Traditional IRA and then take the distribution from the traditional IRA where you can waive withholding. However, you may want to check with your tax professional for assistance with determining whether you should have taxes withheld to satisfy any requirements for paying estimated taxes.
- As you may already know, withdrawing from your retirement plan should be a last resort, as you not only reduce the amount in your nest egg, but you also lose the benefit of having the amounts continue to accrue earnings on a tax-deferred basis. The impact can be quite significant and could put you behind with your retirement program.
- If you have no option but to withdraw amounts from your retirement account, you can roll over the amount within 60 days of receiving the check.
- You may be eligible for unemployment insurance in your state. See the Department of Labor's website for details. This could provide sufficient income until you find another job and negate the need to tap into your 401(k) plan.
You may want to talk to a retirement/financial counselor for some additional financial guidance.
This question was answered by Denise Appleby
Unfortunately, the answer is "no". Income taken from a retirement plan will need to be reported as income for the year it was distributed. Depending on your age, there are a few things you should consider. First, there could be a 10% penalty for early withdrawals from you 401(k) plan. However, if you are using part of your distributions to cover the cost of health care premiums or unreimbursed medical expenses, the penalty can be waived.
If you've been laid off, you'll have access to your retirement account funds. You will not be able to take out a loan like you could have when you were an employee. While it would be best for you to use other funds from savings or even home equity line of credit proceeds, you may access your 401(k) to fund your living expenses.
How much this costs you really depends on your age. If you're under age 59 1/2, you'll likely have to pay income taxes and have a 10% early withdrawal penalty.
If you use some of the funds to help pay for medical insurance premiums, you'll likely be eligible for an exemption of the 10% early withdrawal penalty.
If you're over age 59 1/2, you won't have to deal with the penalty. If you're under age 59 1/2 you can also avoid the penalty by arranging to take out 'substantially equal periodic payments' over the next five years. This is known as the 72(t) rule. You can check out IRS.gov or speak to your tax preparer for more information.
But in all cases, your distributions will be counted as income in the year of the withdrawal. You may want to budget for taxes by having the 401(k) or subsequent IRA custodian take out a percentage for federal and state income taxes with each distribution. Otherwise, you may not have sufficient funds to pay the full tax bill when you file your next tax return.