Raiding Your Retirement Funds? Here’s How to Avoid Hidden Tax Traps

If your only option is to access funds held in tax-favored retirement accounts like IRAs or 401(k)s, though, watch out.

To preserve retirement funds for retirement, the law typically requires people who withdraw money from these accounts before age 59½ to pay income tax plus a stiff 10% penalty. But not always: The cost of early payouts can vary widely, so savers considering one should strategize.

“People are surprised at how heavily taxed early retirement withdrawals are, and they don’t know the strategies for lowering them,” says Martin James, a CPA and adviser with Modern Wealth Management near Indianapolis.

Here is an example of the difference planning can make.

Say a single 30-year-old with a top tax bracket of 22% needs $25,000 to help pay for career-expanding higher education. If she can take those funds from Roth IRA contributions, she won’t owe anything. But if she takes them from a traditional 401(k) plan, she could owe about $8,000 in tax and penalty. (Taking a 401(k) loan is a different matter, discussed later.)

Although savers often think of IRAs and 401(k)s—or similar accounts like 403(b)s—as equivalent because some rules are the same, they spring from separate laws and have major differences.

For example, IRAs are owned by savers directly, while 401(k)s and similar accounts are maintained by employers for workers and have more variations. Funds in 401(k)s are also usually protected from creditors. IRAs may or may not be, depending on state laws.

Differences in the 10% penalty on early withdrawals are also common—and the IRS and Tax Court are seldom sympathetic when people make mistakes.

Keith Lamar Jones, a professor of accounting at the University of Kansas, learned this the hard way. In 2001, he withdrew about $30,000 from an inactive 401(k) to help pay for a Ph.D. and a first home. He paid tax on the withdrawal but not the 10% penalty usually owed by those under 59½, because he thought there were exceptions for higher-education expenses and first-time home buyers.

The Internal Revenue Service noticed, and it assessed a penalty of about $3,000 because the exceptions he counted on apply only to withdrawals from IRAs, not 401(k)s. Jones says the judge was sympathetic but ruled for the IRS because of the law’s wording.

“I’m still mad about it. The IRS chose form over substance,” Jones says. “I could have rolled the funds into an IRA and taken them out the next day without penalty.”

To help savers considering early withdrawals avoid mishaps, here’s useful information. For details, see IRS Publication 590-B.

Tax-free, penalty-free withdrawals from Roth accounts

Savers younger than 59½ avoid both income taxes and the 10% penalty on early withdrawals if they are from dollars that were contributed to Roth IRAs, not the earnings on that money.

The same is true for money contributed to Roth 401(k)s, if company rules allow for such withdrawals. But this rule doesn’t apply to contributions to traditional IRAs and 401(k)s.

For example, say a 35-year-old has been contributing to a Roth IRA since age 18 and has a total of $60,000 in contributions. If he wants those funds for a down payment for a house, he could withdraw them without owing tax or penalty

This provision is one reason some savers look to Roth contributions as emergency funds. To determine total contributions, savers can check with their plan custodians, who typically offer a breakdown of contributions and earnings. But savers should also track contributions and conversions on IRS Forms 8606 and 5498, as it may be hard to get prior information in some cases, especially if a saver has changed custodians.

To be sure, savers don’t owe tax on these withdrawals because the contributions were in after-tax dollars, so taxes were already paid. The main disadvantage here is that the withdrawn dollars can’t be restored, so it means forgoing future tax-free earnings on those dollars.

Penalty-free withdrawals from both IRAs and 401(k)s

Most early withdrawals from IRAs and 401(k)s will incur taxes, but not all incur the 10% penalty. Currently both IRAs and 401(k)s offer exemptions for a number of reasons, although limits can apply.

There are full exceptions for death, disability and terminal illness, as well as for medical expenses exceeding 7.5% of savers’ adjusted gross income. Exceptions also apply for birth or adoption expenses ($5,000); qualified disasters ($22,000); and domestic-abuse victims ($10,300).

Penalty-free withdrawals from IRAs only

The 10% penalty doesn’t apply to early withdrawals from IRAs, including SEP and Simple IRAs, for higher-education expenses, first-time home buyers ($10,000) and the cost of health insurance for many people who are unemployed.

Penalty-free withdrawals from 401(k)s and similar plans only

The 10% penalty doesn’t apply to several types of early withdrawals from 401(k) and similar plans. In particular, workers who retire in the year they turn 55 or later and make withdrawals before age 59½ owe tax but not a penalty on them. (More generous rules can apply for public-safety employees.)

Note: Many plans allow employees to borrow and pay back the loan within five years. The danger here, says James, is that if a worker leaves the company the loan is due immediately, and unless it’s paid back it will be considered a withdrawal. Some plans also allow hardship withdrawals, but they will be subject to tax and the 10% penalty unless covered by an existing exemption.

Another option for penalty-free withdrawals

The law also provides strapped savers with another option: “Rule 72(t)” payments from their IRAs or 401(k)s for at least five years. The 10% penalty doesn’t apply to these withdrawals.

This option sounds good but is perilous, says Brad Pistole, the chief executive of Trinity Insurance & Financial Services in Ozark, Mo. Among other dangers: If the saver misses a payout, then tax, interest, and the 10% penalty could be due retroactive to the beginning of the arrangement. The payments must last until at least age 59½, and sometimes longer.

Pistole says he has 2,000 clients and has done fewer than a dozen 72(t) arrangements since 2010. “They are the last option when nothing else works, usually for early retirees who are 52 or 53,” he adds.

Savers who want to do 72(t) payments should probably get professional tax help.

Source: WSJ