Don't Turn Your Retirement Plan into an Emergency Fund

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In the past two years, more than 16,000 California educators have been laid off. And about 26,000 California educators received pink slips in the first quarter of 2010. It's too early to tell how many may be rescinded, but it's clear that many cuts will be made.

If you've been laid off or received a RIF notice, anxiety about finances comes with the territory. And it may have you looking at the retirement savings in your 403(b) or 457 plan in a new light. You might start to think that those funds could be better used for immediate needs than as the retirement cushion they were originally intended to be.

But before you make a decision you'll regret and never be able to undo, think carefully. If you cash out your 403(b) or 457 plan balance, you could be shortchanging your retirement security. There are many drawbacks to taking a lump-sum distribution from your plan when you're laid off:

  • If you cash out a 403(b) plan, you will owe taxes on the total distribution, and a 10% tax penalty may be assessed if you're younger than 55. That's a hefty hit on your savings. For example, with a $10,000 balance, an educator who is in the 25% federal income tax bracket would owe $3,500 in taxes, leaving only $6,500. (You will owe taxes, but not a 10% penalty, on a lump-sum distribution from a 457 plan.)
  • Your district is required to withhold 20% of the balance for tax purposes.
  • You lose future tax-deferred compounding.* If you leave your savings undisturbed and they earn a 7% annual rate, that $10,000 could grow to $40,387 after 20 years with no additional contributions.** If you cash out of your plan, you could be saying goodbye to more than $30,000 in compounded growth.
  • Once you find another job or are rehired, you may need to work longer to make up for lost savings and compounded returns.

Keep It Growing

Instead of taking a lump-sum distribution from your retirement plan if you're RIF'd (receive a reduction in force notice), explore options that preserve your account balance and allow the funds to continue growing tax-deferred:

  • Leave the money in your current plan. Your provider may allow you to maintain your account, but you may not be able to make further contributions.
  • Transfer the balance to a new employer's plan when you find a new job. This option is not offered by all districts.
  • Roll over your funds to a traditional or Roth individual retirement account (IRA). To avoid having taxes withheld, arrange to have the funds transferred directly from your retirement plan account to the IRA (not to you first).

* Taxes will be due at ordinary income tax rates upon withdrawal from a 403(b) or 457 plan. Premature withdrawals (generally, those made before age 59½) may be subject to a 10% tax penalty, too (does not apply to 457 plans).
** Rate of return is for illustration only and does not represent the return of any specific investment. Your returns will vary.