Jim Lorenzen, CFP®, AIF®
News Flash: Baby boomers are getting older! (film at 11). As if they didn’t have enough to worry about (i.e., parents coming home to live with them, children that can’t seem to leave home, wondering it their money will last through retirement, and an outlook that screams for increased health care costs and taxes), what if there’s an emergency that forces an early withdrawal from a retirement account? What happens if it occurs before age 59-1/2 and the IRS levies a 10% tax penalty on top of the income tax?
Not a happy situation. Someone in a 25% tax bracket who needs $10,000 will have to withdraw $13,333 plus money to cover the penalty…
… unless there’s an exception.
For example, an employee over age 50 who withdraw money from company plans after separating from service can withdraw money from his/her plan without paying the penalty – but, as highly-regarded retirement guru Ed Slott reminds us[1] it’s important to know that not every exception applies to every type of plan. Some exceptions apply to company plans alright, but not all. Some apply to IRAs, but not all. Some apply to both.
Is your head spinning yet? Mr. Slott says he sees the biggest errors with first-time home buyers and people in higher education – situations where the exceptions apply only to IRAs and never to company plans. In one case a school teacher withdrew over $67,000 from her 403(b) for college education expenses only to find out (in tax court) she had to pay the 10% IRS penalty.
Here’s another from the Slott files: A Big-10 accounting firm accountant lost in tax court when he found he had to pay the 10% penalty on top of the taxes for the $30,000+ distribution he took from his 401(k) to begin his Ph.D. studies. Here’s a real shocker: Even a person who has negative income for the year and is able to withdraw funds from an IRA tax-free even after the distribution income is factored-in, will still have to pay the 10% penalty – yes, even if there’s no income tax! This one lost in tax court and again on appeal. The 10% penalty is completely independent of the level of income for the year.
Medical expenses are another possible trap, according to Mr. Slott. In one case, someone withdrew a little over $17,000 from her qualified play to pay for medical treatments that began in the same year. Payment for the treatments, however, was made the following year. The IRS assessed a 10% penalty, a little over $1,700. She lost. The expenses had to be paid in the same year the money was withdrawn. It’s important to remember that the medical expenses must qualify as deductible, meaning it must exceed the income threshold for claiming the deduction, which increased to 10% of AGI (adjusted gross income) for 2019. The exception is still available even if the taxpayer uses the standard deduction.
As you can see, there are a number of tax-traps when withdrawals from retirement plans (IRA or company plans) are used to meet emergencies.
Mr. Slott argues – and I have argued as well – this is why it’s important for advisors and their clients to set-up tax-free sources of income, such as non-IRA funds – money that’s already been taxed – so the money will be available for those emergencies when they arise.
It’s not something you can do at the last minute; but, it is something you can plan for IF you plan ahead.
Hope this helps,
Jim
[1] Financial Planning, June 2019. Ed Slott is a practicing CPA and a nationally recognized retirement expert, often appearing on PBS conducting highly entertaining and informative educational sessions.
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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and an ACCREDITED INVESTMENT FIDUCIARY® serving private clients since 1991. Jim is Founding Principal of The Independent Financial Group, a registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.
