3 Reasons to Avoid the 401k Tax Spiral

Do you get eager to use your 401K or IRA money? Emergencies are certainly going to arise from time to time. When they do, people are often all too eager to use their 401k or IRA money to bridge that gap. This is a terrible idea for many reasons but I will touch upon three right now.

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401K Loans Carry Risk

People often have other funding sources available to them such as emergency fund, access to credit, or access to a 401k loan. While using an emergency fund would be a better choice, access to a line of credit or a credit card can also work in your favor in this case. A variant of this solution is to access credit to pay for the emergency and then stop making 401k contributions while you pay off your credit balance.

A 401k loan can also be an option but it carries risk. If you change employer, the full outstanding balance will become due. The balance must be paid in full, or else the loan is deemed a distribution. You will be liable for tax and penalty. If you have multiple retirement accounts, the tax treatment might be different for each one; in this case, you should give us a call to review the specifics of your circumstances, we’ll be glad to help.

You Must Report a Retirement Distribution

The second thing I have seen time and again is failing to report an IRA distribution because “I already paid the tax.” That is not how tax withholding works. Not reporting a retirement account distribution is like filing your tax return without a W-2. All your income gets lumped together to compute your income tax including retirement account distributions.

The More You Make, The More They Take

The second piece of this that I see is that people grossly underestimate how much tax will be due on an early distribution. As a general rule I tell people to expect roughly 50% total tax on early distributions even though I often see withholding rates of 10%-15% Federal tax & 5.1% (Mass) tax. Why should you not be surprised by an effective tax rate of 50%, even though you are in a lower tax bracket?

Our tax rates are progressive. This means, the more you make, the more they take. Okay, so what if you are on the high end of the 15% tax bracket? Virtually every dollar you take out of your retirement is going to get taxed at 25%. Not on that, there will aslo be the 10% penalty, plus 5.1% for Mass. That is only 40%. BUT, your child tax credits, student loan interest deduction, unreimbursed employee business expenses, etc., are all being phased out or reduced with every extra dollar of income, This means you can easily add an additional 10% to the amount of tax you will pay on an early distribution.

You Could Owe More Money Than You Have

Finally, let’s say you did the first two things. Now you owe Uncle Sam a bunch of money that you don’t have. You might consider this an emergency and will use your IRA or 401k money to bridge the gap. That puts your right back to where you started from and you will be in need of money again.

Are you in a 401K Tax Spiral?

As we said, borrowing against your IRA or 401K money can be a terrible idea. And, as we also mentioned, If you have multiple retirement accounts, the tax treatment might be different for each one. In this case, you should give Alex Franch, BS EA at Worthtax a call at 781.849.7200 to review the specifics of your circumstances, we’ll be glad to help. Worthtax has locations in Quincy, Weymouth and Dedham.

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