401K

With the current economic crisis on everyone’s mind, you may be wondering if you should withdraw money from your 401K. Experts recommend that you do not. They advise that contributions should continue based on the “buy low-sell high” theory.

What does this mean for you? Simply stated, right now most individuals may have incurred a severe loss in their 401K plans. But, considering that the stock market has dropped approximately 5000 points since the economic decline, your portfolio will no doubt increase with stocks, bonds, and mutual funds that can now be purchased at a very low rate.

If you withdraw funds from your 401K, the cumulative effect will result in your taking a double loss. First, by paying a penalty for early withdrawal - and second, by decreasing the amount of purchasing power you would have as a result of the stocks tumbling to their lowest rates.

You may withdraw funds from your 401K at age 59½. If you withdraw beforehand, however, you will incur a 10% penalty and pay tax on the amount distributed.

You do have another option. Since most economists believe we are headed for a recession, you can roll over your 401K into a Roth IRA or traditional IRA. If you decide to do so, here is some advice from the IRS:

Rollovers from your 401(k) plan. A rollover occurs when you receive a distribution of cash or other assets from one qualified retirement plan and contribute all or part of the distribution within 60 days to another qualified retirement plan or traditional IRA. This transaction is not taxable but it is reportable on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. and your federal tax return. You can roll over most distributions except for:

* A distribution that is one of a series of payments based on life expectancy or paid over a period of ten years or more
* A required minimum distribution
* A corrective distribution
* A hardship distribution
* Dividends on employer securities

Any taxable amount that is not rolled over must be included in income in the year you receive it. If the distribution is paid to you, you have 60 days from the date you receive it to roll it over. Any taxable distribution paid to you is subject to mandatory withholding of 20%, even if you intend to roll the distribution over later. If the distribution is rolled over, and you want to defer tax on the entire taxable portion, you will have to add funds from other sources equal to the amount withheld. You can choose to have your 401(k) plan transfer a distribution directly to another eligible plan or to an IRA. Under this option, no taxes are withheld.

You may borrow up to 50% of your vested account balance up to a maximum of $50,000. The loan must be repaid within 5 years, unless the loan is used to buy your main home. The loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan.

However, if you cannot afford to pay back the loan, it is considered a distribution if you default on three consecutive payments and the funds withdrawn will be taxed.

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In short, the answer is yes - absolutely. Here are the reasons why. Let’s assume you took a substantial hit to your 401K plan when the stock market plummeted approximately 5000 points.

The amount of stocks, bonds, mutual funds, and other holdings that your 401K provider continues to purchase at a very low price will eventually increase in price once the stock market rebounds. If you do not contribute, you will be losing out on the potential increase your overall portfolio will obtain.

The economic rule of thumb is to buy low and sell high. Now is therefore the best time to make substantial contributions to your 401K, especially if you are a young individual who has just entered the business world or if you are five to ten years from retirement. It’s a good idea to check with your 401K plan provider or employer to determine what the maximum contribution is and, if at all possible, whether you can meet that amount annually.

If you cannot afford to maximize your contributions, you can determine what percentage you can afford per paycheck so that at least you are contributing something to the plan. For example, let’s assume you can only contribute 5%. Take time to set a household budget and then determine how much you can afford to contribute to your 401K. Perhaps you can start with 5% and increase it by 1% each year, until you reach the maximum allowed.

A 401K is non-taxable except in an extreme case wherein you are financially strapped and need to withdraw all the money. In this case, you will be taxed for early distribution. There are other options available to you. If you need money for your child’s college tuition or to pay the mortgage, you can apply for a hardship distribution.

You can also apply for a loan of up to 50% of the total amount accumulated. However, it would have to be paid back in five years and if you default three consecutive months in a row, it will be considered a distribution and is therefore taxable.

While most economists estimate that the current economic crisis will last approximately 18 months or longer, it is advised that you seriously consider whether or not you want to utilize this money. Remember, the 401K provider will continue to increase the amount of equity in your plan now, and at a time when stocks are at their lowest, you can lose out in the long term if you stop contributing.

Having a 401K plan is an important of your financial future. Whether you stop contributing or not is up to you, but it is recommended that you contribute something every paycheck so that when the economy turns around, you will at least have some funds available to you in case of an emergency.

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