Will You Need a Retirement Drawdown Strategy?
You’ve been pushed out of the workforce before you’re ready to retire. Your severance, savings and unemployment insurance may not be enough to make ends meet even after you have created a survival budget and minimized your debt payments. This is when you might consider tapping your retirement savings, pension or Social Security until you find another job. Here are the eligibility requirements as well as the pros and cons of each choice.
Claiming Social Security Retirement Benefits
The earliest you can start receiving Social Security retirement benefits is age 62. Apply for benefits three months before your 62nd birthday if you want to get your first check when you turn 62. Otherwise, you can apply up to four months in advance of the date you want your benefit payments to start. To qualify for Social Security, you must have 40 work credits. You get one credit for each $1,300 you earn (in 2017; qualifying earnings were lower in previous years) and you can collect a maximum of four credits per year, so most people qualify for Social Security with 10 years of work.
Social Security benefit payments are based on your 35 highest-earning years of work. (Learn more in Understanding Social Security Eligibility.) They are also based on your age when you claim. At full retirement age, you receive your full monthly benefit. If you claim benefits sooner, your monthly benefit goes down; if you claim benefits later, your monthly payment goes up.
If you were born in February 1952, for example, your full retirement age is 66. If your monthly benefit check at age 66 (which you would reach in February 2018) would be $2,000, and you claimed benefits starting in August 2016, 18 months before your 66th birthday, your benefit would be reduced by 10% (5/9 of 1% per month, or $200 in this example) for a total monthly benefit payment of $1,800. If you waited until age 67.5, 18 months after you reached full retirement age, your benefit would be increased by 8% per year, or 12% in this example (2/3 of 1% per month, or $240) for a total monthly benefit payment of $2,240. (For more, see Tips on Delaying Social Security Benefits.) If you waited as long as possible to start claiming – age 70 – you would receive your highest possible monthly benefit payment: $2,800. (In reality, you are unlikely to receive this much from Social Security; read What is the maximum I can receive from my Social Security retirement benefit? to learn why.)
This Social Security calculator will help you see how your benefits will be affected based on your claiming age; the calculations may be different from the ones in the example above, depending on when you were born. If you wait until after you reach full retirement age before you file, your benefit will also go up with any cost-of-living increases that go to all Social Security recipients. Another way your benefit might increase later is if you go back to full-time work and some of your highest years of earnings occur at the end of your career.
If you claim Social Security early to help you get by during a period of unemployment, you may have the option to stop receiving benefit checks once you start working again. To do so, you must have been receiving benefits for fewer than 12 months and you must repay all the benefits you’ve received so far. To make this happen, you’ll need to complete and file form SSA-521. The reason some workers take this route is because when they start claiming benefits again later, their monthly payment will be based on the higher amount they’re entitled to at that age.
If it has been 12 months or more, or if you don’t have the money to repay the benefits you’ve received so far (a likely possibility because of your unemployment), and you have reached full retirement age, you can suspend benefits when you start working again, then resume them when you’re ready to retire (but no later than age 70). You don’t have to repay what you’ve received so far. The suspension begins the month after the month when you request it. This option is different from the “file and suspend” strategy you might have heard of that some married couples used to increase their benefits but which is no longer allowed. (For more, see Alternative Strategies to File and Suspend.)
If you keep claiming benefits even if you start working again, your benefits may be reduced temporarily if you earn more than an annual limit determined by the Social Security Administration. The annual limit and the reduction amount depend on how far below full retirement age you are. If you are 63, for instance, you are below full retirement age, so your benefits are reduced by $1 for every $2 you earn above $16,920 in 2017. Once you reach full retirement age, working doesn’t reduce your monthly benefit. You will later get a credit for any temporary reduction in benefits, so don’t worry that working means losing out on Social Security. (See Work and Collect Social Security in Retirement?) Also, any income you receive from unemployment benefits will not reduce your Social Security benefits. (If you have a spouse who will be affected by your Social Security benefit claiming decisions, read How does my spousal Social Security benefit work?)
Drawing on a Pension
If you have a pension, can you and should you start drawing on it early as a way to help pay the bills while you look for work?
Most pension plans offer an early retirement benefit before age 65, according to Robin M. Solomon, a benefits attorney with Ivins, Phillips & Barker in Washington, D.C. “Typically, you will need to satisfy certain age and service requirements, such as reaching age 55 with 10 years of active service,” she says. Depending on the specifics of your pension plan, you also may need to start payments immediately after your job terminates.
Starting your pension before normal retirement age will reduce the amount of your monthly payments, sometimes dramatically: A benefit payable at age 55 might be just 50% of what you’d receive by waiting until age 65, Solomon explains, but some employers have exceptions or smaller reductions for laid-off employees.
It’s also important to be aware that, depending on the type of pension you have and the state you live in, drawing on a pension can reduce your unemployment benefits.
Using a Roth IRA as an Emergency Fund
One potential source of emergency funds that many people aren’t aware of is a Roth IRA. If you have a Roth, you can withdraw your contributions at any time without penalty because you contributed to your Roth with after-tax dollars. (See How to Use Your Roth IRA as an Emergency Fund.) If you’re younger than 59½, you can’t withdraw investment earnings without paying a 10% penalty. But if you’re 59½ or older, you’ve reached the minimum age to start taking qualified distributions without penalty.
Tapping retirement funds for living expenses before you’re retired should be at the bottom of your list of solutions to a cash flow problem. The reason? Doing so can compromise your future retirement security. You’ll have less money in your account to grow through investing and to benefit from compound interest. And you’ll never fully make up for contributions you withdrew, even if you make catch-up contributions. But a Roth IRA withdrawal may be a better solution than paying interest on a credit card or risking strained relationships with friends and family whom you might be tempted to ask for a loan.
If you have to withdraw Roth contributions, try to avoid selling investments at a loss to get the cash you need. Also, be aware that you’ll need to report your withdrawals to the IRS on part III of form 8606 when you file your federal tax return. Finally, when you start working again, you can partially make up for the money you took out by making catch-up contributions of up to $1,000 per year (for those 50 or older) as well as maximizing your basic contributions (the limit is $5,500 in 2018; with a catch-up contribution, the limit increases to $6,500).
Handling Your 401(k)
If you have a 401(k) plan with your former employer, you’ll need to decide what to do with it. You have five choices:
1. Leave it with your former employer. The money remains yours, and you continue to have the same investment options and fees. Your former employer will no longer contribute to your account, nor will you be able to keep contributing to it.
2. Take it to your new employer. When you get a new job, if your new employer offers a 401(k) and allows rollovers, you can roll over your old 401(k) into your new one.
3. Cash it out. The consequences of cashing out your 401(k) can be severe. You’re jeopardizing your future retirement plans and you’ll have to pay income tax at your marginal tax rate plus a 10% penalty if you aren’t at least 55 years old. Your severance package might bump you into a higher tax bracket, making the taxes on your 401(k) distribution higher than you expected. If you must cash out your plan and you anticipate being in a lower tax bracket the following year, Solomon says it would be wise to delay your distribution until then unless you are withdrawing contributions from a Roth 401(k), which would be tax-free.
Withdrawing money from your 401(k) should be a last resort, according to David M. Hryck, a New York City tax lawyer, personal finance expert and partner at Reed Smith. “The amount of money that you have in that fund will be worth far more when you retire then it is now due to compounding interest,” Hryck says. “However, if this is your only option, I would recommend that you roll over the funds into an IRA and move forward from there.”
4. Roll over your 401(k) balance into a traditional or Roth IRA. If you’re moving untaxed 401(k) funds into a Roth IRA, you will have to pay taxes on the amount you roll over, since Roth IRAs only allow after-tax contributions. If you are moving the money into a traditional IRA, you won’t have to pay taxes because traditional IRAs are for pre-tax contributions. If you have a Roth 401(k), which is much less common than a traditional 401(k), you won’t have to pay taxes when rolling it over into a Roth IRA since your Roth 401(k) contributions have already been taxed.
With a direct rollover, also called a trustee-to-trustee transfer, you don't get a check from your 401(k) plan administrator that you then send to the financial institution where your new account will be (an indirect rollover). Instead, the money is transferred directly from your 401(k) to your new account. There are some important mistakes to avoid when doing a rollover, but if you enlist the help of a reputable brokerage firm, the process should go smoothly. (Learn more in our Guide to 401(k) and IRA Rollovers.)
Doing a rollover gives you more control over your money. Instead of choosing from the limited number of investments your former employer made available through your 401(k), you can choose any investment you want. This freedom gives you the opportunity to pay lower investment fees and possibly earn higher returns. (See Are Fees Depleting Your Retirement Savings?)
5. Take penalty-free distributions. If you meet certain criteria, another option is to start taking distributions from your 401(k). Under IRS rules, if you “separate from service” during or after the year when you turn 55, you can start taking distributions from your 401(k) plan or other qualified retirement plan without paying the 10% early withdrawal tax. This exception does not apply to IRAs, SEPs, SIMPLE IRAs or SARSEP plans.
Besides deciding what to do with your 401(k) plan, if you have any plan loans outstanding, you’ll need to take care of those right away. If you have borrowed money from your 401(k) that you haven’t fully repaid yet, most plans will require you to repay the loan balance within 30, 60 or 90 days of your termination from employment, Solomon says, adding that companies can be more generous if they wish, since these repayment timeframes aren’t an IRS requirement. Why, then, is the timeframe usually so short?
“Companies generally avoid offering repayment options after termination because they can no longer simply deduct the loan repayments from a regular paycheck,” she says. “Instead, the employer would need to collect checks from former employees, which can be an administrative headache.”
Check your 401(k) summary plan description (SPD) for the rules and ask your human resources department if there is any flexibility in the repayment terms, but don’t be surprised if the answer is no.
Ryan McGuinness, a Chartered Financial Analyst in the greater Chicago area, says it’s unlikely that you’ll be able to negotiate a longer repayment window. Since the plan is supposed to treat everyone equally, your firm can’t offer you a special deal that isn’t offered across the board. (For related reading, see Saving for Retirement When You Aren’t Working.)
If you can’t repay the loan balance by the deadline, the unpaid amount will be treated as a distribution and you will have to pay taxes and a 10% early distribution penalty on it.
In the next chapter, we’ll explore your options for getting health insurance after a layoff.How to Get Health Insurance After Losing Your Job