The Little Differences Between 401(k)s and IRAs Can Cost Big Bucks

[question everything]

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IRA and 401(k) accounts aren’t the same, and one upstate New York couple ran smack into an arbitrary difference that raised their tax bill 65%. In 2015, Bahman Amadi and Lily Soltani-Amadi needed a bit more cash for a down payment on a house in a good school district. So Ms. Soltani-Amadi withdrew $6,686 from her 401(k) retirement plan. The couple knew they’d owe some tax, but Ms. Soltani-Amadi says a plan representative told her they would avoid a 10% penalty because the payout was for their first home.

That advice was wrong.

Earlier this month, a Tax Court judge ruled that the Amadis owed the 10% penalty on their 401(k) withdrawal. That added $669 to their $1,028 tax on the payout. “I didn’t know about different retirement accounts, but I trusted the representative to know what he was talking about,” says Ms. Soltani-Amadi. She is a college mathematics professor and her husband is a physician.

The Amadis tripped over rules on early withdrawals for home buyers. Because tax-favored retirement accounts are supposed to be for retirement, the rules often impose tax and a 10% penalty on withdrawals before age 59½. Younger IRA owners who take out up to $10,000 to purchase a first home don’t owe the penalty, while younger 401(k) participants do.

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However, if the couple had done a tax-free rollover of the 401(k) payout into an IRA and then withdrawn it, they wouldn’t have owed the 10% penalty because the payout was from an IRA. Income tax would still be due.

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Payouts before age 59½ from an IRA that are used for higher-education tuition, books and other costs are exempt from the 10% penalty. Similar withdrawals from 401(k) plans incur it. Mandatory IRA payouts begin at age 70½ under current law, and the account owner has until April 1 of the following year to take the first payout. With 401(k) plans, the deadline is April 1 following the year the worker retires or turns 70½, whichever is later—unless the worker owns more than 5% of the company providing the plan. As a result, some older employees can roll over existing IRAs into their firm’s 401(k) plan and delay their 70½ deadline for IRA payouts. But the plan has to permit such moves, and not all do.

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https://www.wsj.com/articles/the-little-differences-between-401-k-s-and-iras-can-cost-big-bucks-11567157402 (paid subscription)