by Optima Financial Group | Jan 12, 2022 | Retirement
If you’re facing financial hard times, your retirement funds begin to look like a good source of much-needed cash. In cases of dire emergency, you may indeed be able to make withdrawals from those funds before you reach retirement age. However, the potential short-term and long-term consequences can be severe. Nonetheless, if you must make an early withdrawal from an Individual Retirement Account (IRA) or 401(k), there are certain circumstances under which you can minimize the bite by Uncle Sam.
The COVID-19 pandemic and the 2020 CARES Act have made it easier for taxpayers to withdraw funds from their retirement accounts. Learn more about taking a CARES Act retirement withdrawal HERE.
3 Types of Retirement Funds
There are three primary types of tax-optimized retirement funds in the United States:
- Traditional IRAs
- Roth IRAs
- 401(k)s
Traditional IRAs
Traditional IRAs are drawn from pre-tax earnings. When you deposit funds in a traditional IRA, the taxes on those funds and your earnings are deferred until after you retire, presumably when your income is lower and you qualify for a lower tax bracket.
Roth IRAs
By contrast, Roth IRAs are drawn from post-tax earnings. Because you pay taxes on Roth IRA deposits upfront, you do not have to pay taxes on either the principal or the earnings, provided that your Roth IRA has been open for five years or longer and you are at least 59 ½ years old when you begin making withdrawals.
401(K)
401(k) funds are sponsored by your employer. You can invest either pre-tax earnings or post-tax earnings, with tax implications similar to those for a traditional or a Roth IRA. Many employers match their employees’ contributions dollar for dollar. The catch is that you can’t access your employer’s contributions to your 401 (k) until you are fully vested in the company, which translates to being employed for a certain length of time which varies but five years is common.
For what reasons can you withdraw from an IRA without penalty?
If you are younger than age 59½, taking withdrawals from either a traditional or Roth IRA or from a 401(k) will usually trigger a 10 percent tax penalty in addition to paying any income taxes that are due. However, there are exceptions that vary depending on whether you are withdrawing from a traditional or a Roth IRA or from a 401 (k). You can avoid tax penalties from withdrawing from a traditional IRA even if you are younger than age 59 ½ for the following reasons
- Purchasing a first home.
- Educational expenses for yourself or a family member.
- Death or disability of a family member.
- Covering unreimbursed medical expenses.
- Purchasing health insurance coverage (only if you are not already covered).
To claim one of these exceptions, you will need to complete IRS Form 5329 along with your income tax returns the following year. Even if you avoid the penalty, you will still need to pay taxes on the money you withdraw. This means that you should withdraw enough to cover your needs, plus a little extra for taxes.
Is there a Roth IRA withdrawal penalty?
Yes, penalty-free early withdrawals for Roth IRAs apply to only two circumstances: first–time home purchase or death or disability of a family member. However, the penalty for early withdrawal from a Roth IRA only applies to earnings, since you have already paid taxes on the principal. You will also need to submit Form 5329 along with your tax return.
How do I avoid an early withdrawal penalty on 401(k) retirement funds??
It is possible to make early withdrawals from a 401(k). However, the IRS is especially harsh on early withdrawals from 401 (k) funds. You may make what are known as hardship withdrawals before age 59 ½ for the following reasons:
- Purchase a first home.
- Pay for college for yourself or a dependent.
- Prevent foreclosure or eviction from your home.
- Cover unreimbursed medical expenses for yourself or a dependent.
However, hardship withdrawals from a 401 (k) differ from hardship withdrawals from an IRA. You will be assessed a 10 percent penalty in addition to paying income taxes on your withdrawal. To avoid the 10 percent penalty on early withdrawals from a 401(k), you must fulfill one of the following circumstances.
- Total disability.
- Medical expenses that total more than 7.5 percent of your adjusted gross income (AGI).
- Court order to give the money to a divorced spouse, child, or other dependents.
- Permanent separation from your job (including voluntary termination) during or after the year you turn 55.
- Permanent separation at any age with a plan for equal yearly distributions of your 401(k) (once you begin taking distributions, you must continue them until you reach age 59 ½ or for five years, whichever is longer).
A better option than a hardship withdrawal from your 401(k) may be to take a loan against the value of your 401(k) with an outside lender. The lender places a lien against your 401(k) which remains in place until you repay the loan. Your funds remain in your 401(k), safe from the reach of Uncle Sam. However, if you default on the loan, the lender will have the right to seize your 401(k) to collect payment.
Is it bad to withdraw from an IRA?
It should be clear that IRA and 401k withdrawal should be considered a last resort. Even if you avoid tax penalties, you are depleting the available funds available for your retirement so in this sense, it is a bad idea and if you can avoid it, you should. If you must borrow, borrow enough to cover your obligations plus taxes, and repay the funds as quickly as possible. After all, you are actually repaying yourself – and your future.
Need to speak with a licensed tax professional? Optima Tax Relief provides a comprehensive range of tax relief services. Schedule a consultation with one of our professionals today.
by Optima Financial Group | Mar 20, 2013 | Retirement
This post originally appeared on The Fiscal Times.
When you leave the workforce and give up a paycheck, life seems grand – endless free time, no more alarm clocks, and lower tax rates – or so it seems at first. Even if you’re raking in over a million dollars in retirement savings a year, you won’t have to pay Social Security and Medicare taxes, and some states don’t tax such income either.
But those tax savings won’t get you very far. As you start drawing Social Security checks and supplement them with tax-deferred retirement plan withdrawals and investment income, your taxable income can go up sharply. What really matters is not how much you have in retirement accounts, but what you’re left with after taxes.
Planning your income in retirement – and reducing your overall tax bill – is critical to making your money last. Here are eight ways to manage your tax bite after you leave the workforce.
1. Strategically withdraw from your IRA.
Rules on tax-deferred retirement plans like IRAs, 401(k)s, and 403(b)s allow you to take distributions starting at age 59.5, and you must start withdrawing the required minimum by age 70.5 or face stiff penalty fees. It’s usually better to pull money out when your taxable income for the year will be lower, especially when the total stays under the 25-percent tax bracket (which starts at $36,250 for singles and $72,500 for married filing jointly in 2013), says William Reichenstein, investment management chair at Baylor University.
Being strategic means you’ll pay the 10- or 15-percent rate on those withdrawals. You might take out tax-deferred money, for example, in a year when you have a lot of deductions – when you’re paying high medical expenses, for example, or are making a large charitable contribution, which would significantly reduce your taxable income. For example, you might have one year when your income from a pension is $40,000, but you have medical expenses of $20,000; this would be an excellent time to withdraw from an IRA. If you know you’ll exceed $36,250 (or $72,500 for married couples), it’s best to stay under the next tax bracket. Find the 2013 tax bracket rates here.
2. Pay estimated taxes on your Social Security benefits.
Social Security income is taxable, depending on the amount of your “combined income,” which the government defines as your adjusted gross income, plus any non-taxable interest (interest earned on tax-free municipal bonds, for example), plus 50 percent of your Social Security benefits. For an individual, if your combined income is between $25,000 and $34,000, you’ll pay normal income tax rates on up to 50 percent of your benefits; if it’s more than $34,000, you’ll pay tax on up to 85 percent. Mark Steber, chief tax officer at Jackson Hewitt Tax Service, says you can request that the Social Security Administration withhold those taxes from your checks, but it’s better to make estimated payments yourself because it’s common for combined income to fluctuate a lot, and the amount withheld would likely be too high or low.
3. Consider delaying your Social Security checks.
One benefit of waiting to collect Social Security until you’re older is that your checks will be larger. Though you can start collecting any time between the ages of 62 and 70, for every year you wait, your check will grow by roughly 6.25 percent, says Philadelphia-area financial planner Daniel White of Daniel White & Associates. But taxes also play into it.
In a paper last April for the Journal of Financial Planning, Baylor’s Reichenstein and a coauthor tested the effects of starting Social Security at different ages. They found that someone who retired in 2011 at age 62 with $700,000 in savings and started taking monthly Social Security checks of $1,125 that year would exhaust their portfolio in 30 years at a given spending level. But if they used their own assets to fund their early retirement and started taking their now-much-larger checks of $1,980 at age 70, their portfolio would last at least 40 years at that same spending level. This is in part because only 50 percent of your Social Security benefits count toward the combined-income threshold. Of course, all decisions like this are a gamble — if you die young, it would have been better to start taking Social Security earlier. However, if you have a surviving spouse, he or she would receive all or part of your benefit, depending on their age.
4. Give your children appreciated assets instead of cash.
If you’re planning to give money to the children or grandchildren, one way to do so while getting a tax benefit is instead of cash, give them a stock that’s grown since you bought it, says White. Of course, your family member will pay the capital gains tax when they sell the asset, so for both of you to benefit, the recipient should be in a lower tax bracket than you are – which is likely if you’re helping them out.
5. Convert your IRA to a Roth IRA.
If you can afford to pay the taxes, start converting your IRA to a Roth IRA, says Matthew Curfman, certified financial planner at Richmond Brothers in Jackson, Michigan. Growing your money in a Roth and then being able to withdraw it tax free will protect you against future tax increases. Also, since there’s no mandatory withdrawal on a Roth, it makes an excellent long-term contingency fund – and any withdrawals don’t count in the combined-income formula used to tax Social Security benefits, notes David Littell, co-director of the American College of Financial Services’ Center for Retirement Income.
6. Make charitable contributions from your IRA.
The New Year’s Day fiscal cliff deal resuscitated an expired provision for 2013 that allows people age 70.5 or older to donate up to $100,000 from their IRA to a qualified charity, without having to pay taxes on the transfer. That donation can help satisfy your required minimal distribution. You can’t beat that provision, Curfman says. If you donate $20,000 from your IRA to the charity, the nonprofit gets all of it. But if you withdraw $20,000 out of your IRA and then donate the cash, the IRS taxes it before you make the donation – so if the tax was $3,000, the charity gets only $17,000.
7. Raise the cost basis of your investments when your income is lower.
Low-income years in retirement are a great time to sell a stock that has appreciated and reinvest the gain in stock of a similar class, says Reichenstein. That’s because, under the fiscal cliff deal, the long-term capital gains rate is zero (yes, zero) on people whose income puts them in the 15-percent bracket or lower (up to $36,250 for a single filer and $72,500 for married filing jointly).
In years when you’re in one of those brackets, you can sell a stock you bought originally at $40,000 that’s now worth $50,000 and buy another stock worth $50,000. You’ve raised the cost basis of the stock by $10,000, reducing the taxes you’ll pay if you have to sell it in a year when you’re in the 25-percent or higher bracket. Use caution though, says Reichenstein: Make sure that $10,000 in gain doesn’t push your income for the year high enough that it would cause your combined income to rise to the point that your Social Security benefits are taxed at a higher rate.
8. Move to a tax-friendly state.
If you’re moving for retirement, consider taxes as part of your decision, says Diana Webb, assistant professor of finance at Northwood University. A report last September from Kiplinger identified Alaska, Nevada, and Wyoming as the three states with the most retirement-friendly tax laws. The worst include Ohio, California and New York.
