As a volunteer tax preparer with VITA (Volunteer Income Tax Assistance), I frequently wish people understood taxes better. In recent weeks I’ve done three tax returns for people who, in their first year of retirement, cashed out their entire IRA or 401(k) account (ranging from $15,000 to $60,000).
In most cases, these new retirees used the funds for their long-term benefit – major home improvements and other purchases that will help them in the long run. I think they probably thought about the fact that spending the money now means they’ll live on more limited income for the rest of their lives, and they decided that was okay with them.
But I do NOT think they understood the tax implications of their decision, and I found myself wishing I would’ve had the chance to explain it all before they decided to withdraw the whole amount at once. Here are some things retirees should know:
- Withdrawals from “traditional” IRA, 401(k), and similar retirement plans will generally be included in your taxable income. Large withdrawals can easily move you into a higher tax bracket, meaning that you pay a higher tax rate on some of that income. For a single person, income above about $53,000 is typically subject to a 22% tax rate, rather than the lower 10% or 12% rate.
- The first year of retirement is especially tricky for income tax purposes, because usually the person also had employment income for part of the year, which may contribute to bumping them into a higher tax bracket.
- Social Security income is only partly taxable (at most 85% of it is subject to tax). How much is taxable depends on how much other income you have that year. When a person has very low income, none of their Social Security income will be taxable; as their income increases, the portion of Social Security subject to tax also increases. That means that large withdrawals from retirement accounts can create a double-whammy by increasing the taxable amount of Social Security as well has increasing total income.
I know that some of the clients I served paid at least $5,000 more in income tax than they would have if they had spread their retirement plan withdrawals over five years, or even over two or three years. I’m also pretty confident that they did not really understand the tax impact when they made the decision to withdraw it all at once.
Bottom line? Before making decisions about withdrawing from retirement plans, consider various options and get information from someone who is knowledgeable about taxes. If you don’t have a tax expert to ask, try using IRS form 1040-ES (estimated taxes) OR the IRS online withholding estimator to compare different options. Note: remember to consider state income taxes, as well.