Virtually all economic growth of the past decade can be attributed to housing and the loans that made expansion possible. The collapse of these markets unleashed a financial tsunami; a wave washing away the homes, savings, and future plans the “boom” had created. Millions have lost their livelihoods and retirement. Millions more are struggling to build a seawall between their American “dream” and financial reality. They are depleting their savings and running up equity lines to make ends meet. Even worse: some continue to cash out their retirement to keep creditors from their doorstep.
Withdrawing money from retirement might seem an easy solution to pressing financial problems. But removing savings from a tax deferred retirement account can result in a large, unanticipated tax bill. We have discussed this topic before, yet the extent to which it continues has spurred me to revisit the topic. In this article, I will discuss some basic tax implications of cashing out a retirement account. My goal is to help you minimize your tax burden while protecting your financial future.
Whether your retirement plan is an Individual Retirement Account (IRA), Simplified Employer Pension (SEP), 401(K) or 403(B), it exists to serve one function: to save for retirement. Contributions and earnings to these accounts are not subject to income tax until the money is withdrawn. If, however, funds are withdrawn prior to reaching age 59 ½ these withdrawals will be subject to income tax and an additional “early distribution” penalty (usually 10%) unless a specific exception applies. Funds withdrawn after reaching age 59 ½ are still subject to income tax but not the penalty.
The tax and penalty can add up quickly. For example, let’s assume you are not yet age 59 ½ and have $15,000 in credit card debt. You cash out a portion of your retirement to pay them off. Early the next year the retirement trustee sends you a 1099R for the $15,000 distribution. If your family is in the 25% marginal tax bracket, this $15,000 early distribution will cost you $3,750 in federal taxes, $1,500 in penalties and $975 in state taxes. Paying off your credit cards cost you a total of $6,225 in taxes (41.5%)! Making matters worse: It is highly likely that you will not have the $6,225 needed to pay the tax bill. You will have to work out a payment plan with the tax authorities, put the balance back on the credit cards, or cash out even more of your retirement. Every option racks up more interest and/or penalties.
All tax-deferred withdrawals are subject to income tax. But, as mentioned earlier, there are a few exceptions to the ten percent penalty. Although there are no exceptions specifically for financial hardship, there are several exceptions that may help those experiencing money troubles. Here is a brief list of withdrawals you can make without paying the penalty:
There are more reasons to consult your tax professional, financial advisor and attorney prior to cashing out your retirement. In addition to tax and penalties, your retirement may be worth a fraction of what it was a few short years ago. Withdrawing funds will lock-in these losses and forego the tax-free, compound earnings that may have been generated if the funds had not been withdrawn. Your retirement may also be protected from your creditors, even if you file bankruptcy. On the other hand, the IRS may be able to take your retirement if you are unable to pay the tax on an early distribution.
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