FROM THE EMAILBAG - USING A PREMATURE PENSION WITHDRAWAL TO PAY FOR HOME IMPROVEMENTS

I recently received the following email –

“I moved to Georgia with my wife and daughter and we recently purchased a home! I am planning on rolling over some money from a 401(k) account to my government retirement account. When I do this, I wanted to withdraw some to go into some home projects. I know when I had to do this before you suggested I withhold certain percentages for tax purposes. How much should I have them withhold?”

Here is my response -

“Good luck in your new home in Georgia.

A premature withdrawal/distribution from an employer pension plan is the most expensive, and probably the worst, source of funds.  I do not recommend doing this.

1. You will pay a 10% premature withdrawal penalty.

2. You will pay 22%-24% in federal income tax, depending on your level of income.  {based on my knowledge of the taxpayers' level of income}

3. You will most likely also pay Georgia state income tax (I have absolutely no knowledge of GA state income tax).

You will pay up to at least 40% of the amount withdrawn in tax and penalties.  Only 60% of what you take will remain in your pocket.

It is “more better” to take a loan from an employer account, if the plan allows for loans, than to take an actual withdrawal.

It is also better to use home equity debt if available, which may be deductible if the money is used to “substantially improve” your home.  This is perhaps the cheapest alternative.

Personal loan interest is higher than home equity debt, and not deductible, but it is still cheaper than taking money from an employer pension plan like a 401(k).

If you MUST use a distribution from your employer plan I would have at least 30% withheld for federal income tax and an appropriate amount withheld for GA state income tax, based on your GA marginal tax rate.”

Hey, fellow tax pros – do you agree with my answer?

TTFN

DON'T DO IT!

Many first-time home-buyers take a distribution from their company’s 401(k) retirement plan to help fund the down payment for the purchase of the home.  And, unfortunately, they tell their tax professional about it AFTER it has been done.

This is a bad idea.  The distribution is included in the federal and probably also state taxable income of the taxpayer – at a cost of 25% to perhaps as much as 40% of the distribution.  In addition, if the taxpayer is under age 59½ he or she must pay an additional 10% penalty for early withdrawal – bringing the cost of the distribution up to as much as 50%.  So, a distribution of $20,000 only puts $10,000 to $13,000 in the taxpayer’s pocket.

The overall tax and other financial benefits of home ownership may eventually outweigh the tax cost of a 401(k) withdrawal, but I still say this is still not a good idea.

If there is no other source of funds for the down payment consider taking a loan from the 401(k) plan, if allowable, instead of an outright distribution.  The interest rate on 401(k) loans is usually low, and you are actually probably paying the interest to yourself.  This loan must eventually be paid back, or the outstanding balance will be treated as a distribution when employment with the company ends.  FYI, the interest charged on the 401(k) loan is NOT deductible on Schedule A.

One way to avoid the 10% premature withdrawal penalty when a loan from the plan is not an option is to rollover a 401(k) distribution of up to $10,000 into an IRA account and then take a $10,000 distribution from the IRA account.  Or just take $10,000 from an existing IRA account instead of the 401(k) plan.  One of the exceptions to the 10% penalty for premature withdrawals from an IRA account is a distribution for first-time purchases.  A purchase qualifies as “first time” if the taxpayer did not own a home in the two years prior to the withdrawal.  This exception DOES NOT apply to premature withdrawals from a qualified plan such as a 401(k).

So, if you are thinking about buying a home your 401(k) plan should be the last place you turn to for funding the down payment.  And you should discuss it with your tax professional BEFORE you do anything.

TTFN

DON'T TOUCH THAT 401(K)!

Over the years I have seen many clients who have, without first consulting me, taken money from their 401(k) plans, while still employed, to assist in paying for excessive medical expenses, college tuition, or a downpayment on a home.

This is a very expensive way to get money.  A loan shark might be cheaper!

Money taken from a 401(k) plan will be fully taxed on a federal and state level and, if you are under age 59 ½ when you take the money, as has been the case in most of what I have seen among clients, you will also be subject to the 10% premature withdrawal penalty.

In most cases 40% or more of the amount taken from the account will be eaten up by federal and state taxes and penalties!  So if you take $10,000 from your 401(k) you will end up in pocket with less than $6,000.

It is similar with premature withdrawals from a traditional IRA, but with an IRA you might have a “basis” in your traditional IRA investment based on non-deductible contributions so the entire amount of the withdrawal may not be taxable.  With a ROTH IRA you can withdraw your contributions at any time without tax or penalty.

There are a limited number of exceptions that could allow you to avoid the 10% premature withdrawal penalty – but you would still need to pay federal and state income tax on the withdrawal.  Some exceptions apply to withdrawals from both 401(k) plans and traditional IRA accounts, and some apply only to premature IRA distributions.

You can avoid the 10% penalty if you take money out of a 401(k) plan, or a traditional IRA, “to the extent unreimbursed medical expenses exceed 10% (or 7½% if the lower threshold is reinstated) of AGI”.  So you can avoid the penalty on the amount of medical expenses that would be deductible on Schedule A.

If you take $10,000 from your 401(k) to pay for an excessive medical bill not fully covered by insurance (this would NOT include elective cosmetic surgery) and when you sit down to prepare your tax return you determine that your total allowable medical expenses for the year are $20,000 and your AGI is $110,000, you can avoid the 10% penalty on $9,000 of the withdrawal ($20,000 – $11,000 = $9,000).  You would still pay $100 in premature withdrawal penalty.

But in most cases of client 401(k) distributions the money has been used either to pay for college or for a downpayment on a house.  Money taken directly from a 401(k) plan for these purposes will be subject to the full 10% penalty.

However money taken from an IRA account and used for either of these two purposes is exempt from the penalty.  In the case of a downpayment on a home, the exemption is limited to $10,000 withdrawn and only applies for “first-time” home purchases (no home ownership in prior two years). 

According to the IRS, expenses that qualify under the college exception include –

“ . . . tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance.  In addition, if the student is at least a half-time student, room and board are qualified education expenses.”

The amount of expenses allowed must be reduced by any tax-free educational assistance.

So if you want to invade your 401(k) plan for college expenses or a home downpayment first check with the plan to see if you can have the amount of the withdrawal transferred (rolled over) trustee to trustee from the employer plan directly to your traditional IRA account.  Or take the distribution from the 401(k) and immediately rollover the amount yourself into the IRA account.  When that has been done take the amount of the transfer as a distribution from the IRA account and use the IRA money to make the college or home purchase payments. 

Instead of taking an actual withdrawal from your 401(k) you may be able to take a loan from the account.  Taking a loan from a 401(k) plan is not a taxable event.  However be aware that you must pay the money back to the plan, perhaps with some interest, before you leave the company.  If your employment is terminated you must pay back any outstanding 401(k) plan loan balance within a short period of time or the unpaid balance will be treated as a distribution, subject to income tax and penalty at that time.

The best advice I can give you is do not take the money from your 401(k) plan, or second best that if you are thinking about taking money from your 401(k) plan to pay for anything talk to your tax professional first!  If my clients had come to me they would have saved a lot of money.

TTFN

 

 

 

 

 

 

 

 

 

 

 

AVOIDING THE PENALTY ON A PREMATURE IRA WITHDRAWAL

Here is a real life tax tale – taken from the GD extensions.

I have this couple (the husband was originally a client of my mentor Jim Gill from back in my early days who left and returned to me years later as a “lost lamb”) – the husband is in his early 70s and the wife is 20 years younger.

2009 was a bad year for the couple. The husband had a stoke and the wife lost her job. It was thought that the husband would need to go into a nursing home, but as it turns out he, thankfully, apparently recovered much better than originally expected.

The wife was told that before the husband could be covered under Medicaid for his nursing home expenses she would have to close out and exhaust her pension monies. She took a partial distribution in 2009 and again in 2010 to cover medical and living expenses.

Because the wife was under age 59½% (actually under age 55) the 1099-Rs she received in 2009 and 2010 reported the withdrawal as Code 1 – a premature distribution subject to the 10% penalty. However I was able to avoid the penalty for both years.

While the purpose of the distributions was the disability of the husband it appears to me that the exception for disability would not apply – as the monies came from the wife’s rollover IRA account.

IRS Publication 590 (Individual Retirement Arrangements) states (highlights are mine) –

“If you become disabled before you reach age 59½, any distributions from your traditional IRA because of your disability are not subject to the 10% additional tax.

You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.”

But there were other exceptions available to the wife.

For 2009 I used a combination of 2 exceptions to avoid the penalty.

The wife, having lost her job, was able to take advantage of health insurance coverage under COBRA. Pub 590 tells us that –

“. . . you may not have to pay the 10% additional tax on distributions during the year that are not more than the amount you paid during the year for medical insurance for yourself, your spouse, and your dependents. You will not have to pay the tax on these amounts if all of the following conditions apply.

· You lost your job.
· You received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job.
· You receive the distributions during either the year you received the unemployment compensation or the following year.
· You receive the distributions no later than 60 days after you have been reemployed.”

In 2009 the wife lost her job and received about $20,000 in unemployment.

The amount of COBRA insurance paid did not cover the entire distribution for 2009, so I also used the exception for “qualified higher education expenses”. The couple’s son, claimed as a dependent, was an undergraduate college student in 2009.

Pub 590 explains –

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

The IRA distribution did not have to actually be used to pay the education expenses. There is no “tracking” requirement like the one for classifying interest payments.

“When determining the amount of the distribution that is not subject to the 10% additional tax, include qualified higher education expenses paid with any of the following funds.

· Payment for services, such as wages.
· A loan.
· A gift.
· An inheritance given to either the student or the individual making the withdrawal.
· A withdrawal from personal savings (including savings from a qualified tuition program).”

So the tuition and fees could have been paid using a student loan and not the IRA distribution and the exception would still apply.

Between the health insurance paid and the qualified higher education expenses I was able to wipe out the entire penalty.

For the 2010 distribution I used the qualified higher education expenses exception again – this time for college tuition, fees and costs paid for the daughter. And I also used the exception for “unreimbursed medical expenses”.

“Even if you are under age 59½, you do not have to pay the 10% additional tax on distributions that are not more than:

· The amount you paid for unreimbursed medical expenses during the year of the distribution, minus
· 7.5% of your adjusted gross income . . . for the year of the distribution.”

For 2010 the couple’s deductible medical expenses were well in excess of 7½% of their AGI, and were claimed as an itemized deduction. This exception did not apply for tax year 2009.

Once again I was able to wipe out the entire penalty.

While I have always told my clients that the last place you should go to if you need money for any reason, especially if you are under age 59½, is a retirement account – because you could end up paying 40% or more of the distribution in federal and state taxes and penalties – when there is no way to avoid it you may be able to reduce the cost by using one of the exceptions.

FYI, here is the complete list of exceptions to the 10% penalty for early withdrawal from a “traditional” IRA –

· You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
· The distributions are not more than the cost of your medical insurance.
· You are disabled.
· You are the beneficiary of a deceased IRA owner.
· You are receiving distributions in the form of an annuity.
· The distributions are not more than your qualified higher education expenses.
· You use the distributions to buy, build, or rebuild a first home.
· The distribution is due to an IRS levy of the qualified plan.
· The distribution is a qualified reservist distribution.

All of the exceptions are discussed in detail in Publication 590.

TTFN