Monday, February 14, 2011

Early Withdrawals From Your IRA/401k - Might As Well Gift Wrap It And Give it to IRS

Here's another huge tax misconception:  When you take money out of your IRA or 401(k) before age 59 1/2, you think the 20% they withhold from taxes right off the top hurts, but at least that's all it will cost.  Wrong!  Too often someone withdraws $40,000 so they will have $32,000 left after taxes to "save their house" only to find they owe another $8,000 when they file their tax return!  Why is that and what can you do about it?
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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