Tax Consequences of withdrawal from an IRA or 401K

Posted by on Jul 9, 2013 in Blog, Uncategorized | No Comments

When money gets tight, or an emergency expense pops up, it can be tempting to turn to retirement savings as a way out.  After all, it is your money.  Or, maybe you’re considering taking a loan secured by your 401K to meet your immediate cash needs.  What could be the harm?  At tax time, you could suffer all types of consequences if you are not careful.

A 401K plan, named for the section of the IRS code, is a tax-deferred savings plan.  It allows you to contribute to a retirement plan directly from your paycheck with the gross dollars.  So, before the money is taxed, an amount is aside in an account and invested on your behalf for retirement.  When you reach age 59 1/2, you are permitted to access those dollars without a penalty.

An Individual Retirement Account is very similar to the 401k, though it is not an employer-sponsored account.  There are limits on the amount that you can contribute, and the contribution limits are phased out based on your income.  According to IRS rules, a couple filing a joint return can contribute a maximum of $5500 each to an IRA, until their Adjusted Gross Income reaches $95000.  At that point, the amount they are permitted to contribute begins to phase out.

When you turn 59 1/2, the IRS lifts the penalty for accessing your account.   Ideally, your principle has yielded some return through investment.  You pay your current tax rate on the amount that you withdraw for living expenses.  But, if you are in your 30’s or 40’s, and would like to withdraw that money for a house, medical expenses or a new car, what happens then?

A House

Individual Retirement Arrangement – IRS rules permit a withdrawal from an IRA for a first time homebuyer of up to $10,000, before the 10% penalty applies.  But remember, you still pay the taxes on that money.  A bump in income from a retirement withdrawal can be significant.  Discuss it with your tax advisor first.  If you withdraw over $10000, remember not only will you pay income tax on the entire amount, but an excise tax of 10% on the amount over $10,000.

401Kthere is no exclusion for a first time homebuyer from a 401K.  You will be paying the income tax and a 10% penalty.  So a $10,000 withdrawal means an extra $1000 added to your tax bill no matter what.  The 10% penalty will not be reduced by more exemptions or additional deductions.

Medical Bills

Individual Retirement Arrangement -If you have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income, you may pay the expenses with money from an IRA, and not have to pay the 10% penalty.  Remember, you still pay the tax on that money.  So for example, if your adjusted Gross income is $50,000, the amount over $3750 that is paid with IRA money is excused from the 10% penalty.

401K-Same rules as the IRA

New Car

 Individual Retirement ArrangementHopefully, you have purchased a wonderful new car that has fulfilled you in every way…because you will pay the income tax and the 10% penalty if you touch your retirement account to do so.

401Ksee above

For more information check out http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics—Tax-on-Early-Distributions

401k Loan

A 401K loan is a loan using your retirement savings as collateral.  Though it seems safe, as though you are loaning yourself your own money, there are some risks.  Many plans use payroll deduction, and the participant is simply repaying  the loan through payroll deduction.  It’s a great deal for the lender.  The loan is secure.  However, what if the employer does not correctly withhold the amount per paycheck to repay the loan?  If a loan payment is missed, the balance is treated as a distribution, and the tax and the penalty apply.

Let us assume that your employer is responsible and your payroll department is infallible.  What if a competing company offers you a 20% raise and a corner office?  You are ready to move on.  What becomes of that 401k loan?  When you leave the company it becomes payable in full.  If you are not prepared to pay it, you will be paying the 10% penalty and the income tax.

http://www.irs.gov/Retirement-Plans/Fixing-Common-Plan-Mistakes—Participant-Loans-in-401(k)-Plans

Rachel West is a staff accountant at Arlint CPA. She practices in the areas of tax preparation and tax research.