Do You Want to Pay Taxes? 401(k) and IRA Distributions Consequences

Who in the right mind would answer yes? I’ve had several clients that have taken a distribution from either a 401(k) or an IRA. They were asked by the plan administrator if they wanted to pay taxes. Their answer was of course, “No”.

What the administrator should have said is “We are withholding 20% of the distribution as a payment to the IRS that goes toward your total tax bill. You could owe more or less taxes on the distribution; it depends on your particular situation.  We can withhold a larger percentage if you want us to.”

The money inside a 401(k) has not been taxed, yet. The money in a Traditional IRA probably has not been taxed yet.  I say probably because it is possible to make a nondeductible contribution to an IRA.  When you take a distribution from one of the plans, the IRS is going to require that you pay taxes on the distribution amount that has not been taxed. However, the distribution is not considered in isolation; it is added to all of your income.

For example, let’s say that you earn $90,000 per year from your job, and you take a $10,000 distribution from your IRA. Adding the two together, your total income for the year is $100,000. And that is the amount that will be used to determine your taxable income.  Depending on your deductions, it could be that you are in the 25% tax bracket, or 10% tax bracket.  So, you don’t know what the correct amount of tax is that should be withheld at the time of the distribution. But, you should try to make an educated guess based off of your prior or current year tax situation.  Either ask the plan administrator to withhold that amount, or set the money aside yourself.

By the way, there is an early distribution penalty of 10% on the taxable portion of the distribution, if you are under 59 ½ years old. Although there are exceptions to the penalty, many people do not qualify for the exceptions and are unpleasantly surprised at tax time.  Try to either consult your financial advisor or a tax pro like an Enrolled Agent, before you take a distribution from your retirement plan.

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Income Tax Preparation in Austin Texas
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