Raiding Your Retirement Funds? Here's How to Avoid Hidden Tax Traps
Sometimes in an emergency you just have to break the glass. While tapping a retirement plan for an early withdrawal should always be a last resort, it can be unavoidable. The cause could be a job loss, a natural disaster like a wildfire, or even an opportunity like a coveted house for sale. If your only option is to access funds held in tax-favored retirement accounts like IRAs or 401(k)s, though, watch out.
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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.
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.
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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. 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.
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. Savers who want to do 72(t) payments should probably get professional tax help.
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