Making the wrong decision about how to use your 401(k) can result in substantial taxes, penalties and an unnecessary reduction of your retirement assets.
If you take the money in a check paid to you, the employer automatically withholds 20 percent of the money for taxes. If you are younger than 55, the IRS adds a 10 percent penalty. If you decide you made a mistake, you have 60 days to replace the money plus the amount your employer withheld.
But if you do a direct rollover into an Individual Retirement Account, no taxes will be taken out. The 401(k) plan will make a check payable to the new trustee for your benefit. In most cases, this will be a traditional IRA. This money will grow, tax-deferred, until you take it out. At that time, it will be taxed as ordinary income. You are required to take a portion out every year once you reach the age of 70 ½ .
You have an additional choice. You could select a Roth IRA which will allow tax-free distributions if certain requirements are met. You will be required to pay the income taxes upfront, but not the penalty. There is no required distribution. This is best for people who do not need the money immediately.
You may be able to receive a stream of periodic payments either from your employer's plan or your IRA. This is called a 72(t). By receiving the money this way, you will be taxed only on the payments you receive. The remainder of your account can continue to potentially grow tax-deferred. The distribution must be taken for the greater of five years or attainment of age 59½. Once you make this choice, it can't be changed.
Regardless of which option you choose, you need to think it through and make the decision that is best for you.
Spurrier is president of M. Spurrier Financial Services LLC. She can be reached at (585) 271-5280.
This column is written by members of the Rochester Women's Network (rwn.org).