Economy gotcha taking $$ out of your 401(k) to survive? Be prepared for tax-time...

by
Dec 18, 2008


The Bottom Line The withholding taken out of your distribution will most likely not be enough to cover all of the tax.

With the slew of job lay-offs going on and the cost of living spiraling upwards, many people will most likely find it necessary to withdraw money from their 401(k) or IRA (Individual Retirement Account) plans in order to get by. Others may think that they have to withdraw the balance in their 401(k) plans because they no longer work with the employer they started the plan with. Neither option is necessarily a bad one, but one thing that continues to strike me in the seven years I have prepared individual income tax returns is how little people understand about the tax consequences of making these withdrawals.

First--taking this money out is taking money out of a Retirement Plan
Many people do not realize that by taking money out of a 401(k) or IRA plan before turning 59 1/2 years old, they are indeed receiving money from a retirement plan. In IRS language this is "taking an early withdrawal distribution." What that means is that they are taking money out of funds they set aside for their retirement before being "old enough" to take that money out tax-free.

Loans from Retirement Plans
Several 401(k) plans offer the option of borrowing from the money already set aside in the account without a penalty. Usually this money needs to be paid back within a set time (1-5 years, depending on the company's policy). As long as the money is paid back on time, there will be no tax repercussion. However, if they do not pay the loan back on time, the company will issue a 1099-R form at that point, and the rules for an early withdrawal distribution will apply.

Contrary to whatever thoughts people may have, you can not take a loan from an IRA, regardless of whether it is a Traditional or Roth IRA.

Examples of why/how these distributions might happen
The most common instance of early withdrawal distributions that I saw after the economic downturn in 2001 occurred when people stopped working for an employer, either by choice or as the result of a lay-off. Most, if not all, 401(k) plans do not allow you to keep your money in that plan if you are no longer working for the employer you set the plan up with. So, when you stop working for that employer, that particular 401(k) plan needs to be closed down. Your options at this point are to take all of the money (a withdrawal) out, or roll the account balance into another 401(k) plan, or an IRA.

Often times, you must work for an employer for a certain amount of time before you can open a new 401(k) plan with them. If you are not sure whether or not you will have enough time to set up a new 401(k) plan, the safest thing to do (for tax purposes) is roll the account balance into an IRA. While you can move the money into either type of IRA (Traditional or Roth), there are fewer steps involved (and no tax consequences) if you move it into a Traditional IRA. If you do not have an IRA already opened, most brokerages allow you to open an IRA with a rollover. A couple of companies will also allow you to open an IRA with a zero balance, so that it is available whenever you need to roll the money in, but this is so rare that I would definitely make sure to ask your salesperson very specifically about this.

If you do the rollover, make sure to roll the entire amount of the 401(k) balance into the new account, because there will be tax and penalty on any amount withdrawn and not rolled over (more on that below).

What I saw most commonly in the last round of massive lay-offs, was that people received a letter from their 401(k) brokerage stating that they needed to either give them account information to roll the money over within X amount of days, or the brokerage would send them a check for the account balance (give them a withdrawal). When this happens, the company will automatically withhold 20 percent of the account balance for Federal Withholding. For reasons I will explain shortly it is extremely important to remember that this is often not enough to cover the entire tax penalty!

What Uncle Sam takes from this withdrawal
If you don't understand the U.S. income tax system very well, and your eyes have not yet glazed over, take a swig of coffee, because this section is what most people have trouble understanding and it is the most relevant.

The most basic way to explain things is to start out by stating that the IRS expects U.S. taxpayers to declare every dollar they receive during a given year on that year's tax return. This does not necessarily mean that everything is fully taxable (for example, stock sales can take into account how much said stock was purchased for), but it does have to show up on the tax return. One of the primary benefits of a 401(k) or Traditional IRA is that the money that you, the taxpayer, puts into it is not taxed in the year you put it in.

In most cases involving a Traditional IRA, you will just subtract from your income the amount you contributed (put in) to your IRA in the 'Adjustments to Income' section of your 1040 (that's the tax form).

In the case of a 401(k), the amount of wage income will be understated on your W-2 (the form that tells the IRS how much you earned) by the amount you contributed to your 401(k) that year. For example, if you earned $50,000 in 2008, but contributed $5,000 to your 401(k), the IRS will see in the first box on your W-2 that you earned $45,000 in 2008.

The reason you don't get taxed up front on the money you put into these retirement plans is that when you withdraw the money, for whatever reason, you will need to pay tax on the entire amount you withdraw. So, when you make any withdrawal from a 401(k) or Traditional IRA, you will need to declare that as income on your tax return.

For many people who understand that they have indeed taken a withdrawal from a retirement plan, this is not a huge shock--yet.

You want your money back before your old enough? Uncle Sam wants more!
Anytime someone takes out a premature distribution (withdrawal before being 59 1/2 years old) from a retirement plan, they are fined an automatic penalty of 10% of the distribution/withdrawal amount. This is after applying other credits (such as higher education, childcare, or foreign tax credit) to your tax, so you can't rely on those credits covering the penalty.

There are a few exceptions to this penalty, such as to pay for higher education (only if withdrawn from an IRA), medical expenses above 7.5% of your income, and up to $10,000 for a down-payment on a first home (also only with an IRA).

A note on Rollovers
One thing to keep in mind is that if you receive a check for your plan's balance and then decide to do the rollover (which you have 60 days to do), you will also need to deposit an additional amount equal to the tax that was withheld when you received for the distribution.

For example, if you withdrew $500 from your 401(k), the plan's administrator withholds $100 (20% of 500). You receive a check for the difference of $400. Within 60 days, you decide to deposit that money into an IRA, so it will count as a rollover. If you deposit the $400 that you received, you will still have $100 that is taxable and subject to the early withdrawal penalty. In order to fully avoid any tax consequences for the current year, you will need to also deposit an additional $100 within that 60 day period (there is no way to get back the original $100 withheld until tax time).

So, where does this leave most taxpayers?
I don't want to complicate things by getting into the nitty gritty of the tax system, so I am going to give a very generic description here. There are several variables that can change things (for example, how much mortgage interest the taxpayer paid during the year), but in general, the majority of the middle class (earning $60,000-$100,000) ends up in at least the 15% tax bracket. This means that after subtracting some deductions the government allows you from your income, you pay close to 15% of the net amount (taxable income) in federal income tax.

This means that in addition to the 10% early withdrawal penalty, you will also have to pay close to 15% of income tax on the early distribution from the 401(k) or Traditional IRA. Basic math tells us that comes out to 25%. Remember how much is the maximum that will be withheld? 20%. So, you will most likely be under-withheld.

What complicates things even more is that for people who have a significant amount of money in the plan before withdrawing it (generally $20,000 is enough to do this), taking an early distribution will often bump them up to the next tax bracket of 25%. In this case, the withdrawal will cost you roughly 35% total in taxes, while only 20% was taken out. That is a considerable shortfall.

One way to combat this is to set aside the difference you expect it to be (either 5 or 15%) and keep it in the bank until tax time. Another, perhaps better, way is to send that money to the IRS as an estimated payment (using form 1040-ES). This way, it will count along with your federal withholding as money you will already have paid toward your tax.

Bringing it all together
When faced with unemployment or under-employment, many people will find themselves dealing with money already set aside in a retirement plan. Whether they unintentionally get the money sent to them, or take it out to pay the mortgage, they will face tax consequences of this. Most likely, they will walk in to the tax desk thinking "my boss already took care of the taxes on this." As a result, they will most likely be in for a big shock. As long as you are aware of the tax consequences, paying the extra money could hurt, but you shouldn't be shocked by it.


Note: this is the best category I could find under the 'Tax Advice' headings for this information. If anyone knows of a better place for it, please let me know and I will move it.


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