The Hidden Tax Trap of 401K Withdrawals – Avoid This Costly Mistake!

My client withdrew approximately $75,000 from a traditional 401K and withheld a little over $9,000, which is roughly 12%. That 12% withholding is severely inadequate for two reasons.

First, even in a normal year, he would be in the 22% tax bracket, which means that 12% already leaves him 10% short. Since he withdrew $75,000, that 10% shortfall amounts to $7,500 of additional tax that needs to be paid. Some of this amount is actually being taxed at 24%, meaning that the shortfall could be as high as 12%, or $9,000.

Second, this individual is not yet 59 and a half years old, which means he faces an additional 10% penalty. This penalty amounts to $7,528, adding to the tax burden. In total, he owes at least $15,000 beyond what was withheld from the 401K withdrawal.

Given this situation, the fact that he only owes $9,000 in taxes is actually a fortunate outcome. His withholding was insufficient, and he would have had an even larger liability had he not received good refunds in previous years. However, this year, he will not receive a refund.

I always advise my clients against withdrawing money from their 401Ks while they are still working. Even when withholding is applied, it is almost never enough, and it frequently leads to tax issues. In this case, because the client withdrew such a large amount, it created a particularly significant problem.

This situation serves as a real-life example of what I continually warn my clients about. My client withdrew $75,000 from a 401K, withheld 12% (which is more than the typical 10%), and still ended up under-withholding by $15,000. This completely wiped out his expected tax refund and left him owing $9,000.

I frequently blog and create videos on this subject, and I always advise my clients to consult me before making a retirement plan withdrawal. Sometimes, there are ways to avoid these issues or alternative solutions that may be more beneficial.

When I review his taxes, I will determine the reason for the withdrawal. Often, when the withdrawal is this large, it is because the individual changed jobs and decided to cash out their 401K. Some people believe that it is acceptable to empty their 401K when purchasing their first home. While there is a benefit for first-time home buyers, as they can exclude $10,000 from the 10% penalty, this still leaves them with a substantial tax burden.

Many individuals mistakenly believe that they do not have to pay taxes on their 401K withdrawals. I am unsure where this misinformation originates, but it certainly does not come from the IRS. Ultimately, I want to remind everyone to be cautious when taking money out of their 401Ks, especially while they are still working or in a year in which they have earned income.