The Internal Revenue Service has put out this article “Early Retirement Distributions and Your Taxes”. I want to discuss it because it has been a major issue for many of my clients. In fact, I have a running joke whenever a client hands me a form 1099-R (the form that people receive when they take a distribution from a retirement plan) that they “did this to make me look bad”. It seems that any time a client takes an early distribution from a retirement plan that it destroys their refund and sometimes even causes them to owe tax when they would otherwise receive refunds. This is true even if they “took the taxes already” which only means that some tax was withheld. Generally speaking, the withholding that is done is inadequate. There are also “hidden costs” to a 401(k) or other retirement withdrawal. I wanted to discuss this article when it came out, but it came out during the height of the tax season, so I pushed it aside.
If someone takes an early distribution, which is to say that they are below the age of 59 ½ when taking the distribution, then they are subject to a federal penalty of 10%. This penalty is on top of whatever tax they may owe. Generally speaking, people taking an early distribution are already in the 15% tax bracket, meaning that the federal government is going to take 15% of the distribution as federal income tax, plus take 10% as a penalty. I have seen a number of cases where the distribution was large enough to put the client into the 25% tax bracket. When that occurs, the government takes 25% of that portion of the distribution as federal income tax plus the 10% penalty, meaning they are taking 35% of that money.
Having the federal government take 35%, or even 25%, is problematic. Some clients do not withhold tax at all. Even those that do typically only withhold 20%. Only rarely have I seen cases where 20% was enough to cover the tax on the withdrawal. For a single person whose income, including the withdrawal, is over $20,000.00 for the year, 20% is not going to be enough. Also keep in mind that in addition to the federal government taxing the withdrawal, the State of Massachusetts, and any other state that has an income tax, also taxes the withdrawal. Fortunately, Massachusetts does not have a penalty for early withdrawal, but many of my clients who have the 20% withheld for the Federal Government do not have any withholding for the State. Massachusetts takes 5.15% of the withdrawal.
This creates another crazy situation which is that people are paying over 30%, and sometimes over 40%, of the money that they withdraw in tax. There are a number of ways to avoid this problem. If you are withdrawing money simply because you need the money, a 401(k) loan is better than an early withdrawal. A 401(k) loan is not a taxed, so long as it is repaid. If you are withdrawing your 401(k) because you have changed jobs, it is better to roll over the 401(k) into an IRA or into your new 401(k). These rollovers also result in no tax liability. Rollover IRAs are very easy to do and most banks and brokerage houses will do the paperwork for you. Finally, it is possible to mix and match. I have seen clients take very large withdrawals that have pushed them into the 25% tax bracket when they did not need all of that money immediately. The most common example is the client who retires. He may leave the company and thus need to close the 401(k). He needs retirement money because he is now retired, but he does not need all of it now. The solution is to take a little bit to get through the year, and put the rest into a rollover IRA. Then the following year, they can take a little bit more out to get through that year and each year thereafter do the same. In this way, they at least avoid taking such huge withdrawals that they push themselves into the 25% bracket. It also enables them to turn 59 ½ and avoid penalty if they retired early. By the way, if it is an early retirement and the person is less than 59 ½, it is possible to avoid the penalty by setting up regular distributions from the IRA. This is something you would do with your IRA administrator and not your tax preparer, but it is something that is easily done. If done correctly, it will avoid the tax penalty.
I mentioned that there are certain “hidden costs” to 401(k) withdrawals. I have seen clients who participated in the 401(k) at their old job and change to a new job where they also participate in a 401(k). Because they changed jobs, they closed their old 401(k) and took their money. By doing that they lost their “saver’s credit” which is a tax credit for people who participate in 401(k)s. I once had a client lose a $200.00 saver’s credit because of a $10.00 401(k) withdrawal. A 401(k) rollover or 401(k) loan does not affect the saver’s credit.
I have also had clients lose other income based tax credits, including the Earned Income Tax Credit, the Child Tax Credit, and even the American Opportunity Tax Credit because of 401(k) withdrawals. By way of example, a single person with two children making $25,000.00 in 2015 will get an Earned Income Tax Credit (EITC) of $4,092.00. If that same person withdraws $10,000.00 in one year from a 401(k), their EITC drops to $1,986.00. Then on top of that, they have a $1,000.00 penalty for the early withdrawal and another $1,031.00 in additional taxes. That extra $31.00 is because the person is just barely nudged into the 15% tax bracket. Were they to withdraw another $1,000.00 from the 401(k), that would result in another $100.00 in penalty, another $150.00 increase in federal income tax, and a further reduction of the Earned Income Tax Credit to $1,775.00. So in this example, an $11,000.00 401(k) withdrawal results in a reduction of the tax refund by $4,598.00. That is akin to the federal government taking 41.8% of the 401(k) withdrawal. Plus the State of Massachusetts would take another 5.15%. Massachusetts would also reduce its Earned Income Tax Credit by $348.00. People making a bit more than the person in this example may find that their Child Tax Credit starts to wither away or even goes away. People who make a more substantial income, and have children in college may see their American Opportunity Tax Credit be reduced or eliminated by virtue of a 401(k) withdrawal.
It always bothers me that I only become aware of the problem after they have done the withdrawal, and they give me their 1099-R Form. At that point the damage has already been done and there is nothing I can do to fix it.
I really do feel bad when I am unable to get clients the tax refunds that I normally get for them because they made a mistake in how they handled their 401(k). As a result, I am encouraging people who for one reason or another feel the need to tap their 401(k), IRA, or other such retirement plan to come and talk to me BEFORE they fill out their withdrawal paperwork. If I filed your last tax return, or if you are an existing client of my Law Office, then this consultation will be free. This consultation will keep me from “looking bad” in the future. I would ask you to bring your most recent paystub. If I did not do your tax return, I need your tax return when you come to see me. For anybody else, I will charge $100.00 for the consultation. I have had a number of clients who I could have saved thousands of dollars if only they had seen me before, rather than after, they had done the withdrawal. By giving my clients this consultation, I can avoid “looking bad” when I do their taxes in the future.