Well, whatever you withdraw is (of course) on top of all the other income you receive. Often it will put you in the next tax bracket. What I see most often is that someone in the 15% bracket winds up in the 25% bracket, and what is it that gets taxed at 25%? The IRA/401(k) withdrawal. Next there is the 10% penalty for early withdrawal, which has only a very few, very hard to qualify for exceptions. So now we're up to 35%. Then you have state tax, generally at least 5%, and in many states the withdrawal pushes you into a bracket nearer to 10% -- so now you're at 40 to 45% tax.
Then there is the sneakier ways it gets even worse. You may very well get caught by AMT (the dreaded alternate minimum tax) that you wouldn't have otherwise, so that some of your itemized deductions are denied. Or the higher income may mean you don't qualify for earned income credit, child tax credit, education credits, or any number of other programs you may have been counting on and would have qualified for had it not been for this withdrawal. All of these have the same impact as if the tax rate were raised even higher.
To add insult to injury, if you are unfortunate enough to live in California, they have a 2.5% early withdrawal penalty on top of the 10% federal penalty.
Bottom line: If you escape with anything less than 50% tax on an early retirement plan withdrawal, you are lucky in a really sadly ironic way. In my initial example, "just" a 40% total tax rate would have given the result I mentioned -- 50% would be even $4,000 worse.
Please! Retirement money is for retirement. Find another source. Any other source. I hate to say it, but this is a time even maxing out your credit cards is preferable to withdrawing from a retirement plan without qualifying for one of the penalty exceptions.
If you do it anyway, you might as well gift wrap it when you give it to the government. Too many times, I see people doing "serial withdrawals". They make a second (and third and ...) withdrawal because it's the only way they can pay the taxes they didn't see coming on the first withdrawal.
If you're even thinking about this, at the very least talk to someone first so you know what you are getting in to in your specific circumstances. If you have a personal experience with this, please share it with us in the comment section below. If you have a private concern, my e-mail is dougbeecher@yahoo.com and I'd be happy to hear from you. Thanks for reading!
Photo credit: Roll Of Money by Anna Cervova
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Thank you for your comment, Vicky. I'm not sure what it has to do with the subject of early withdrawals from retirement plans, so I hope you will clarify that please.
ReplyDeleteThis actually is really bad in some cases. Edward Jones advised my mother that she could put my sister on her IRA and then upon her death my sister could distribute the funds equally to my brother and myself! NOW we are stuck because my sister cannot distribute the funds at all without a huge tax penalty and everything in the IRA is only listed with her as beneficiary.
ReplyDeleteWhy they told us to do it this way is beyond fathoming. Can my sister and the siblings set up ANY kind of accounts where she can transfer our share without a penalty and without her taking a huge tax bite since the funds would not be accessible to her?
This is really bad because it places my sister in the situation where she cannot distribute our share fairly. WE can pay tax to her on what she gives us but then we are getting a pittance in comparison to what she is allowed to keep in there for herself.
this is NOT what my mother intended and not what my sister wants to do.
Do we have any recourse for Edward Jones adviser giving my family such bad advise? They know because my mother told them that she wanted my sister to be able to distribute the funds and they told her to do it this way since my sister is "the only one who lives close by" What?
This has put all three siblings through a big amount of stress and worry and could potentially cause hard feelings without us having any power over that.
There ought to be some vehicle where she can transfer our portion to us and not be hit so hard on HER taxes which my brother and I would have to deduct from our share leaving us with much less than she would get to keep in the IRA.
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