Changing jobs? Tax experts say what NOT to do with a 401(k)

One of the nation’s largest associations of tax professionals has a few tips for Americans who might be facing tough financial times and are considering tapping into their 401(k): Don’t do it.

And if you’ve changed jobs, you also shouldn’t try to add funds to the 401(k) program you had under a previous employer. Why?

Because the National Association of Enrolled Agents (NAEA) says that once you’ve been laid off, you are not allowed to make contributions to your 401(k). Depending on your company’s vesting policy, it’s possible you could even lose some of the employer’s contributions that are in your 401(k).

Here are some guidelines as to what you should do with your 401(k) if you’ve lost your job according to Cynthia Jeanguenat, EA of the National Association of Enrolled Agents (NAEA).

First, DON’T cash in your 401(k).
This should be your last choice. “Generally, any distribution from your 401(k) that you receive before age 59 ½ is considered an early distribution,” says Jeanguenat. “Those early (or premature) distributions are subject to a federal 10 percent early withdrawal penalty in addition to the federal and state income taxes due.”

Here’s how that plays out: Let’s say you have $50,000 in your 401(k) and you are in the 25 percent federal tax bracket and have a state rate of 7 percent. The federal tax of $12,500, plus the state tax of $3,500, plus the 10 percent penalty of $5,000 will leave you with just $29,000 and a huge tax bill unless you have some tax withheld when you receive the distribution.

Second, it’s okay to do nothing.
If you have $5,000 or more in your 401(k), it may be possible to leave your money where it is. Unfortunately, you will not be able to add money to the account, you will not receive any matching money from the company, and you will not be allowed to borrow from the account. In any case, this is a good option because the money will still grow tax-deferred.

Third, you might consider a rollover.
When you find a new job, you may be able to roll over your 401(k) to your new employer’s plan. This depends on the company and whether its plan allows for rollovers. Another option is a direct or indirect rollover to an IRA. You can roll over your money into a variety of investments, including stocks, bonds, mutual funds and CDs. A direct rollover saves you the taxes you’d incur if you cashed out your 401(k).

Indirect rollovers are a little more complicated and you could end up paying taxes on part of the funds.

If you haven’t lost your job, but think you might, NAEA advises that you immediately open an emergency fund that is separate from your 401(k). Having three month’s salary saved up is always a good idea. Another suggestion is to reduce your expenses. One good way to do that is to refinance your home. With the low interest rates in effect, now is a good time to reduce your monthly payments by refinancing.

Of course, no two situations are alike, so NAEA recommends that you contact an enrolled agent or other credentialed financial professional for advice on how to manage your 401(k) if you lose your job. Enrolled agents are federally-authorized tax practitioners who have technical expertise in the field of taxation and are empowered to represent taxpayers before all administrative levels of the IRS.

To find an enrolled agent in your area, visit the “Find an EA” directory at www.naea.org.