Online Extra: Don't Spoil Your Nest Egg

Losing your job doesn't have to mean losing your retirement savings. Here's advice from S&P on how to minimize the hit

In recent years, millions of American workers have been laid off as companies have grappled with a lackluster economy and sagging stock market. Among the tough choices faced by the newly unemployed: what to do with their retirement plan assets?

Many of the laid-off, confronted with the prospect of meager unemployment checks and a long job search ahead, opt to cash out of their plans. A study by management consulting firm Hewitt Associates found that nearly 70% of workers chose a cash distribution upon job separation.

But that can be a costly choice. Cashing out involves a large tax bite and forfeiture of one's hard-earned retirement nest egg. Far better ways exist to make ends meet while unemployed than dipping into retirement savings. Let's examine some of those strategies, after first looking at the choices the newly unemployed have with regard to their retirement plans.

If you get downsized and you're not immediately moving to a new company, you generally have three options for your retirement plan assets:

Stay put. You may be able to leave your savings in your existing plan if your account balance is more than $5,000. By doing so, you'll continue to enjoy tax-deferred compounding potential and receive regular financial account statements and performance reports. Although you'll no longer be allowed to contribute to the plan, you'll still have control over how your money is invested among the plan's investment selections.

Cash out. You may elect to get your money in one lump sum or in installments over a set number of years. A lump-sum approach has a number of drawbacks, including a 20% withholding on the eligible rollover distribution, which the plan is obligated to pay the IRS to cover federal income taxes, and a 10% early-withdrawal penalty if you separate from service before age 55. Depending on your tax bracket and state of residence, you may be liable for additional taxes. Taken together, you could lose up to 50% of your money to federal, state, and local income taxes and penalties (see ).

Money paid under an installment approach, whereby distributions are made in substantially equal payments over the participant's or the participant's and spouse's life expectancy, isn't subject to withholding or penalty, regardless of your age. But this is a fairly complex option that may require the assistance of a financial adviser.

Roll over. You can move your retirement plan money into another qualified account, such as an IRA, using either a direct or indirect rollover. With a direct rollover, the money goes straight from your former employer's retirement plan to your IRA without you ever touching it. The advantages of a direct rollover include simplicity and continued tax deferral on the full amount of your plan savings. IRAs also afford more investment choices than many employer-sponsored plans.

In an indirect rollover, you take a cash distribution, less 20% withholding, but must redeposit your qualified plan assets into an IRA within 60 days in order to avoid paying taxes and penalties. With this approach, however, you'll have to make up the 20% withholding out of your own pocket when you invest the money in the new IRA, or else that amount will be considered a distribution and a 10% penalty will be applied. The 20% is that was withheld is applied to your federal tax bill for the year.

The Costs of Cashing Out*
Lump-sum cash distribution $10,000
less 20% tax withholding $(2,000)
equals the amount in your pocket $8,000
Lump-sum cash distribution $10,000
less 10% IRS penalty $(1,000)
less ordinary federal and state income tax* $(3,300)
equals your aftertax distribution $5,700

* This hypothetical example assumes a federal tax rate of 28%, a state tax rate of 5%, and no local tax. Tax rates vary from state to state and your rates will differ. This example has been simplified for illustrative purposes and is not meant to represent advice.

Investment returns cannot be guaranteed.

During times of economic hardship, it may be tempting to take money intended for future needs and use it to supplement a temporary income shortfall. But before doing so, look hard at other potential sources to meet your current income needs. Some of these might include:

• Savings accounts or other liquid investments, including money-market funds or other easily liquidated investments. With short-term interest rates at historically low levels, the opportunity cost for using these funds is relatively low.

• Home equity loans or lines of credit not only offer comparatively low rates but interest payments are generally tax-deductible. The best approach here may be to set up an equity line of credit beforehand, while you're employed, so that funds will be available when you need them.

• Roth IRA contributions. If you do find it necessary to resort to using some of your retirement savings, consider first cashing in your Roth IRA, if you're 59 1/2 or older and make the withdrawal five years after the first calendar year for which a contribution was made. (For more on Roth IRAs, see the IRS's Publication 590.)

If, after everything else, you still find it necessary to cash in your retirement-savings plan, consider rolling it into an IRA first, then withdrawing only what you need. Also, try to time it after yearend, when you may be in a lower tax bracket.

Remember that taking a cash distribution may have significant repercussions on your long-term savings goals. Let's return to the hypothetical $10,000 withdrawn in the . Not only does that payout exact a heavy toll in taxes and penalties but it involves a significant opportunity cost as well. That amount, placed in a tax-deferred account with an assumed 8% annual rate of return, would grow to more than $46,000 in 20 years.

The bottom line: The funds you take out today could severely diminish your retirement nest egg tomorrow.

From Standard & Poor's Financial Communications, which provides newsletters, educational materials, and other information to financial-services companies

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