There are many situations where people find reasons to cash out a 401(k) retirement plan. Sometimes it happens with a job change. Other times a divorce leads to splitting the balance in one spouse’s retirement account. It is done for other reasons, too.
Recently I talked with someone who withdrew a substantial sum from her then-husband’s retirement plan as part of a divorce. It seemed like a good idea at the time, but it has turned into a huge black cloud hanging over her head.
Why? Because she didn’t understand the tax implications. An early withdrawal from a retirement plan affects your taxes in two ways:
- There’s a 10% Federal tax penalty because you withdrew before retirement age. For example, if you withdrew $50,000, the 10% penalty would be $5,000.
- The amount you withdrew is added to your taxable income for the year. If your taxable income (after deductions and exemptions) was $20,000, a $50,000 401(k) withdrawal makes it $70,000. On the federal return, that’s enough to bump you from the 15% tax bracket into the 25% tax bracket. It will increase your state taxes as well. The result, for this example, could easily be an extra $10-15,000 in federal and state taxes – perhaps more (on top of the $5,000 penalty for early withdrawal).
The woman I talked with had been told by the 401(k) company that they would withhold taxes, but they didn’t withhold nearly enough. Add on interest (for late payment) and she’ll be probably be paying that tax bill for at least 10 years.
I felt horrible for this woman and the hardships she is facing, but there was nothing I could suggest that would change her situation. What I can do, though, is to continue to share information, hoping to help others to avoid this situation. Remember:
- In a job change or divorce, you don’t have to withdraw from a 401(k) – instead, you can roll the funds into an IRA. This prevents tax hassles and builds retirement security.
- If you do consider an early withdrawal from a 401(k) plan (for whatever reason), be sure to consult a tax specialist who understands the details of your situation. You will still need to pay the taxes, but you’ll plan for that up front and prevent a decade-long debt to the IRS.
Early withdrawals from a 401(k) take careful planning. ~Barb
Barb Wollan is a Family Finance specialist and a VITA volunteer tax preparer