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ANSWERED on Sat 14 Apr 2007 - 12:23 am UTC by nancy

Question: Tax Consequences of Cashing Out Retirement Accounts

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Fri 13 Apr 2007 - 12:49 pm UTC

Question

nelson
Customer

I would like to know the tax consequences of cashing out retirement
accounts when leaving an employer, rather than rolling over the funds to
another qualified account or leaving them in the employer's accounts.  I
live in New York City.  I have two accounts:

1) A 401(k) plan funded by both payroll deductions and firm match.


2) A defined-contribution pension plan funded solely by the firm.

Thank you.

 
 

Fri 13 Apr 2007 - 8:46 pm UTC

Uclue Researcher Request for clarification

John E
Researcher

If you cash them out, it seems fairly obvious that the lump sum payments then fall under the category of simple income.

Is there some implication I'm missing in your question, or some thought you have as to why this would not be the case?

 

Fri 13 Apr 2007 - 9:08 pm UTC

Question clarification

nelson
Customer

I guess I forgot to state a few facts.  I am 32 years old.  The 401(k) payroll deductions were tax deferred contributions.  I'm pretty sure this means there's a penalty, which I believe is 10% but I would like verification of this.  Additionally, I believe the employer has to withhold 20% for federal tax, which would be reconciled on the year's tax return.

 

Sat 14 Apr 2007 - 12:23 am UTC

Uclue Researcher Answer

nancy
Researcher

Hi Nelson,

Yes, you'll have to pay 10% in federal tax and your employer will withhold 20% on that 401k.

Unless you're in desperate need of that cash, you should either leave it in your current employer's plan (unless you're leaving to take another job and the employer you're leaving doesn't allow that, or your 401k is under $5,000);or roll over that money into other retirement investments, like IRAs.

Otherwise, unless you qualify for a few very specific hardship tax exemptions, you'll be facing considerable tax expenses.

See the IRS's page on early distribution from 401ks:
http://www.irs.gov/taxtopics/tc424.html

The IRS:
http://www.irs.gov/faqs/faq-kw137.html

"I changed jobs and my old employer sent me a check for my 401(k) money withholding 20% for Federal Income Tax. I rolled over the distribution to my 401(k) plan at my current employer within 60 days. Since money was withheld from the 401(k) distribution, do I have to include that money as income?

"If the amount rolled over was the net amount, that is, the amount of the distribution less the tax withheld, then the 20% withholding amount not rolled over is included in gross taxable income and may be subject to a 10 percent additional tax on early distributions from qualified retirement plans. Use Form 5329 (PDF), Additional Taxes on Other Qualified Plans (including IRA's), and Other Tax-Favored Accounts, to report the penalty.

"If the amount rolled over was the gross amount, that is, you added an amount equal to the withholding to the amount that was rolled over, you would not add any of that amount to gross taxable income this year or owe a 10 percent additional tax on early distributions from qualified retirement plans."

To get an idea of how much you may owe in taxes if you do cash out, do your calculations, based on your tax rate, in Richmond Financial's (of Staten Island) calculator:
http://www.richmondfinancialassoc.com/content.cfm?ContentID=695

And that doesn't include state taxes!

RECOMMENDATIONS FROM EXPERTS:

From RolloverAid, see these suggestions:
http://www.rolloveraid.com/

"Your 401k withdrawal options are as follows if you are under 59 ½ [and you are]:

"-Take a lump sum distribution, in which case your 401k plan provider will write you a check for the value of your account less a 20% withholding tax mandated by the IRS, and a 10% withdrawal penalty. The 20% tax that is withheld, but NOT the 10% penalty, will be counted against your income tax payable or will be counted towards any refund due for the tax year when you file your tax return. Some 401k penalty free withdrawal exceptions are here.

" -You can do nothing and leave it with your previous employer as long as the amount is greater than $5,000. Amounts less than $5,000 will usually be distributed to you, *less a 20% withholding tax*, regardless of you age. (Check with your plan sponsor)

" -Do 401k rollover into an IRA or a solo 401k (if you are planning to open your own one person business)"

Not surprisingly, all the other financial sites and experts I checked recommend rolling over retirement funds, especially if under the age of 59 1/2 and if you don't meet exemptions (such as permanent disability). They are adamant that early distribution is costly in the short, and long, term.

"Cashing Out Your 401(k)," by Miranda Marquit, All Business, Dec.1, 2006:
http://www.allbusiness.com/personal-finance/3878837-1.html

"[I]f you are not at least 55 years old, you will have to pay a 10% early withdrawal fee. All of this can cut into your funds significantly. Even loans against your 401(k) come with hefty fees. You would actually be better off to roll your 401(k) into an IRA, which has more flexibility in taking out loans against the retirement plan. . ."

From the Ceridian Connection Newsletter, June 2006:

"Cash out or keep saving: Retirement plans and changing jobs"
http://www.ceridian.com/myceridian/connection/content/1,4268,13764-61517,00.html
"Many employees choose to cash out their retirement plans rather than roll the funds into a new account when changing employers. Not only is this a bad idea, it happens at an alarming rate."

You'll see they recommend rolling that over that money into a Roth IRA.

If you're going into a new job that offers a 401K, you should be able to rollover your existing 401K monies into that  account.(Btw, if you encounter resistance to rolling over your 401K at your current job, try following Marquit's advice:  . . ."Try visiting the human resources department. Speak with the company's retirement plan overseer. These people are paid to help you understand the process and take the proper steps to manage your retirement plan.")


CONSIDER THE CASH-OUT MAY MOVE YOU INTO A HIGHER TAX BRACKET

I'm not sure if you've secured a a new job. If so, this article may be of some help, especially if you ultimately land in a lower paying job.

"Between Jobs? That's the Time to Safeguard Your 401k," by Clifton Linton, mPower:
http://www.401khelpcenter.com/mpower/feature_092302.html

You also see another red flag re: the possibility of bumping yourself into a higher tax bracket:

"Suppose you are 45 and have $50,000 in your 401k. A withdrawal of that size would put you in the 27 percent federal tax bracket ($13,500 in taxes). Add the 10 percent penalty ($5,000) and you will be left with only 63 percent of your account balance ( $31,500). State income tax will reduce your net even more. Remember that 401k withdrawals are taxable income -- so if you earned $50,000 for the year, this withdrawal will give you a total income of $100,000."

TAX EXEMPTIONS FOR EARLY WITHDRAWAL:

You really only want to cash out retirement funds in hardship cases, in which you qualify for tax exemptions.

From About.com's "Tax Planning" site, by guide William Perez:

http://taxes.about.com/od/preparingyourtaxes/a/1040line59.htm

"Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan:

* Distributions upon the death or disability of the plan participant.
* You were age 55 or over and you retired or left your job.
* You received the distribution as part of "substantially equal payments" over your lifetime.
* You paid for medical expenses exceeding 7.5% of your adjusted gross income.**
* The distributions were required by a divorce decree or separation agreement ("qualified domestic   relations court order". ..)"

H&R Block's "Early Distributions Penalty":
http://www.hrblock.com/taxes/tax_tips/deductions_credits/company_pension.html

Here's more helpful information on exemptions, from the NY law firm Elhilow & Maiocchi:
http://www.emattys.com/lawyer-attorney-3F305C93-9D95-4B5A-92804E1A80700A67.html

NEW YORK STATE TAXES - RETIREMENT FUND TAXES

We know the feds will take 10% of your 401k cash-out. But what about NY State? I wasn't able to come up with a definite figure, but I have pprovided contact info for the appropriate department. (Below.)

First, let's consider what will happen if you don't liquidate those monies.

From the April 13, 2007 edition of The Pocono Record, "Do New York commuters deserve a reputation as tax avoiders?," by David Pierce
http://www.poconorecord.com/apps/pbcs.dll/article?AID=/99999999/NEWS090103/51216006/-1/NEWS0923

"New York, for example, doesn't tax 401(k) retirement contributions and other forms of deferred compensation."

So, you can see the tax advantage of putting money into, not taking money out of, a NY retirement account.

To learn what you'll eventually have to pay during retirement, provided you're still in NY State, see the Retirement Living Information Center:

http://rds.yahoo.com/_ylt=A0geu.bhph9Gq2cBAHRXNyoA;_ylu=X3oDMTE5dTV1ODQ3BGNvbG8DZQRsA1dTMQRwb3MDMQRzZWMDc3IEdnRpZANNQVAwMTRfM

TAz/SIG=121rjlveq/EXP=1176565857/**http%3a//www.retirementliving.com/RLstate3.html

Scroll down to

"Personal Income Taxes"
Tax Rate Range: Low - 4.0%; High - 6.85%
Income Brackets: * Lowest - $8,000; Highest - $20,000
Number of Brackets: 5
Personal Exemptions: Single - $0; Married - $0; Dependents - $1,000
 . . .
. . .Retirement Income Taxes: Social Security, military, civil service, state/local government pensions are exempt. *Also, up to $20,000 of qualified private pensions for those 59½ and older*."

$20,000 exempt is a pretty comfy amount! 

ESTIMATING TAXES FROM EARLY DISTRIBUTION:

Call or visit the NY State Department for Taxation and Finance:
http://www.rpea.org/pensiontaxes.htm

"Tax Info (800) 225-5829." (I called, but could not connect to a counselor. I think I might have called too late in the day.)

You can try them again Monday (I recommend calling before 4:00 p.m., the usual quitting time for government workers), or search their Web site:
http://www.nystax.gov

See this page for "Estimating Tax":
http://www.nystax.gov/pit/estimated_tax/how_to_estimate.htm
It tells you just which forms to download (you need Adobe Reader) and playing around with those figures should give you a good idea of what you'll have to pay to NY State if you cash out your retirement nest eggs now.

CONFINED-CONTRIBUTION PENSION PLAN:

As for "defined-contribution pension plan," it looks like you'll again be hit with taxes for early cash-out. See "FAQs About Cash Balance Pension Plans," at this Department of Labor page:
http://www.dol.gov/ebsa/faqs/faq_consumer_cashbalanceplans.html

"What is a cash balance plan?
There are two general types of pension plans-Defined Benefit Plans and Defined Contribution Plans . . ."

Scroll down to

"How am I affected if I leave my job at a company that just changed its pension plan from a traditional defined benefit formula to a cash balance plan formula?

"If you have worked long enough to be vested under the plan, you should receive the sum of:

"The accrued benefit under the formula in effect before the amendment.

"Any additional benefits you earned under the plan formula in effect after the amendment. However, you may have to wait until a retirement age under the plan to receive your benefit.

"For more about vesting and distribution of benefits, see What You Should Know About Your Retirement Plan."

Go to that page:
http://www.dol.gov/ebsa/publications/wyskapr.html

Scroll down to the table:

"Table 1. Characteristics Of Defined Benefit And Defined Contribution Plans

If you leave the employer prior to retirement: "The employee may transfer the account balance to an individual retirement account (IRA) or, in some cases, another employer plan, where it can continue to grow based on investment earnings. The employee also may take the balance out of the plan, but will owe taxes and possibly penalties, thus reducing retirement income. Plans may cash out small accounts."

I'm not sure just which kind of plan you have or how much is in it. For a general idea, see "Request for Payment of Defined Contribution Plans":
http://www2.icmarc.org/ImageCache/plan3/content/pubs/plan3paymentrequest_2epdf/v1/plan3paymentrequest.pdf

On Page 2, see "2. There May Be Tax Implications." Your employer will withhold 20%, just as with your 401k, and if you're under 59 1/2, you'll have to pay taxes on the cash-out, but no indication of the possible amount is given.

Just as with a 401k, you have the opportunity to avoid taxes by rolling over that money into IRAs or into a new employer's pension plan.

When you talk to the NY State Department for Taxation and Finance about how much you'll have to pay the state on your 401K distribution, you should also ask them about disbursement from this account. It's very possible they can also give you an estimate of how much you'll pay in federal taxes on this, based on not only the amounts of the disbursements, but your tax bracket.

For more background, see "Highlights of the Pension Protection Act of 2006 for Defined-Contribution Pension Plans," from Securian Retirement:
https://web2.securianretirementcenter.com/PDF/Articles/PPA2006.pdf.

Whether you decide to roll over all or part of the cash, if you're still not certain what to do, consult a Certified Financial Planner. Planners who charges a flat fee for their time are generally recommended, rather than advisers who take a percentage of profits once they begin managing your investments.

I hope my research is of help to you. If you have difficulty navigating any links or require clarification, please post a Request for Clarification and I'll assist you further.

Best regards,
Nancy

Search Strings:

tax consequences + cashing out 401k
tax consequences + cashing out 401k +New York
New York State AND tax AND 401(k) penalty OR penalties
defined-contribution pension plan +early distribution
401k +early distribution +tax OR penalty
New York State tax code

 
 

Sat 14 Apr 2007 - 1:22 am UTC

Uclue Researcher Answer clarification

nancy
Researcher

This additional information from the IRS may also be helpful to you:

From the already cited:

http://www.irs.gov/faqs/faq-kw7.html

"If I retire or am laid off before I am 59 1/2, can I withdraw the funds accumulated in a 401(k) plan, without having to pay a 10% penalty?

"In most cases, if you withdraw funds from your 401(k) plan before you are 59 1/2, you must pay the 10 percent additional tax on early distributions from qualified retirement plans on any amounts that are not rolled into an IRA. However, there are some exceptions listed in Publication 560, Retirement Plans for Small Business, and Publication 575, Pension and Annuity Income."

Then see:
Topic 412 - Lump–Sum Distributions
http://www.irs.gov/taxtopics/tc412.html

And

Topic 558 - Tax on Early Distributions from Retirement Plans
http://www.irs.gov/taxtopics/tc558.html

"To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10% tax on certain early distributions of these funds..."

The IRS exemptions to these early withdrawals are also listed at that page.

 

Mon 16 Apr 2007 - 12:25 am UTC

Accepted and rated

nelson
Customer

Thanks for the extensive research.

 

Mon 16 Apr 2007 - 2:37 am UTC

Uclue Researcher Comment

nancy
Researcher

Thanks for the tip and five stars, Nelson. Glad I was able to help you!

An addendum: I came across one possible way to liquidate, without incurring substantial taxes. 

From FindLaw:
http://public.findlaw.com/social_security/nolo/ency/D9696686-5434-4049-BE3F90D611FE9298.html

"Substantially Equal Periodic Payments

"The substantially equal periodic payment exception is available to anyone with an IRA or a retirement plan, *regardless of age*.

"Theoretically, if you begin taking distributions from your retirement plan in equal annual installments, and those payments are designed to be spread out over your entire life . . .then the payments will not be subject to an early distribution tax.

" . . . If you want to begin withdrawing funds from your employer's plan, you must have terminated your employment before payments begin. . ."

Best regards,
Nancy

 

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