Thursday, June 11, 2009


Years ago, in the late 80s or early 90s (I don’t recall exactly when), the construction industry in New Jersey was going through what the entire country is going through now.

My mentor’s office, which eventually became mine, was located across the street from headquarters of the Ironworkers Union Local, and we had several union members as clients.

Because of the dire economic situation many of the ironworkers were forced to dip into their union pension and annuity fund to make ends meet. Of course they wanted as much cash in hand as possible, so they had minimal (10%) or no federal and state income tax withheld from the pension withdrawals.

As a result at tax time they were hit with huge balances due to both “Sam” and the State of New Jersey. When the 10% premature withdrawal penalty was added to the ordinary federal and state tax rates, and you factored in the affect the increased AGI had on various deductions and credits, the total effective tax cost was 40-50% of the gross distribution!

In order to pay the tax due to their “uncles” they had to take more money out of the plan, and incur more tax and penalty the next year. It was a vicious cycle.

Similarly, over the years many young couples have taken withdrawals from their 401(k)s or IRAs or other pension plans during the year to get the money for the down payment on a home – and were in shock when I told them what they owed their “uncles”.

While, in the long run, the couple would receive substantial tax savings from owning a home - just like with the ironworkers the initial tax cost of taking money out of their pension was truly excessive.

The couples usually had 10% or 20% in federal income tax withheld from the withdrawals, but no state income tax. When they told me, “But we had the tax taken out before we got the money” I had to counter with, “THE tax was not withheld – only a small portion of the tax was taken out”.

Plus, many couples think that once they buy a house they will automatically get tons of money back in tax refunds each year – and are surprised when they see their first 1040 as homeowners. The later in the year the home is purchased, the smaller the tax savings realized. A home purchased in the fall or winter often does not yield any first-year tax savings.

So in these bleak economic times learn a lesson from the NJ ironworkers and young first-time homebuyers. Your 401(k) or traditional IRA or any other pension or annuity plan should be the very last place you turn to get cash for any reason – pretty much just before visiting the local loan shark.

As discussed above – depending on your various tax brackets, when you take money out of these types of plans you will be giving up to half of it to the federal, state and, in some cases, local governments!

Often you can borrow from your 401(k) plan – up to a maximum of 50% of your account balance. Depending on how the plan is written the borrowing may only be permitted for specific reasons – so you should check out the specific details of your plan. In such a case you have not received a taxable distribution from the plan.
Of course, as with any other loan, the money must be paid back, often within 5 years. You must be careful - if you default on the loan, or terminate your employment before the loan is paid back in full, you will be taxed, and subject to the 10% penalty, on the remaining loan balance.

You can not borrow from an IRA, but you can take a withdrawal and avoid tax and penalty if you put the money back into an IRA within 60 days of the date of the distribution (that is 60 calendar days and not 60 business days). So you can, in effect, take a truly short-term loan from your traditional IRA.
The full amount of the distribution must be "rolled over" within the 60 day period. If you take out $10,000 and $2,000 is withheld for federal income tax you must roll over the full $10,000, and not the net $8,000, back into an IRA. You must find the $2,000 from another source or you will pay tax and penalty on $2,000.
Money taken from a ROTH IRA is first treated as a return of “after-tax” contributions – so you will not be taxed or penalized until you begin to withdraw actual earnings.


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