Avoiding This Common 401k Mistake
Avoiding This Common 401k Mistake
As a financial advisor, I occasionally have clients who come to me for advice AFTER they have already attempted to solve a problem on their own. Now, being self-sufficient isn’t a bad thing at all, but when you are dealing with IRS regulations of the tax code you can end up in a mess if you don’t understand the tax ramifications. In this blog, I will discuss one such situation that walked through The Resource Center doors, a 401k mistake.
The client, at age 55, changed jobs. This client had a 401k plan through his former employer with a balance of $50,000 and had a $13,000 loan from that 401k. The new job did NOT offer a 401k retirement plan, after 3 months (90 days) the client found a better opportunity with a third employer who DID offer a 401k.
When the client left his old job that had the 401k, he made a withdrawal of the entire account. When he received the check he noticed the amount of the check was less than he expected. The 401k plan had a mandatory 20% Federal withholding, typical for a withdrawal prior to 59 ½. Unaware of that rule the client gave me a call to try and help get his money back. Remember, he left this job and went to job #2 (the one without a 401k plan), and after 3 months (90 days) he moved to job #3 with a 401k plan.
When this client came in to meet with me, their desire was to move the remaining $40,000 into an IRA to avoid the tax.
This client was trying to operate under the “Rule of 55”. The “Rule of 55” basically says that if you’re 55 years of age and you get terminated or you get laid off, the IRS allows you to access your 401k without a 10% early use penalty. You still must pay taxes on the withdrawal. However, the client went about trying to use this rule all wrong. You can only roll your 401k from your “Previous CURRENT Employer”, remember his previous current employer is Job #2 without a 401k plan available.
What Actually Happened
When the client withdrew the lump sum of his 401k balance it became subject to a mandatory IRS rule that requires a 20% withholding for taxes. The managing company withheld 20%, leaving the client with a remainder of $40,000.
Now if you recall the client had taken out a $13,000 loan from his 401k. When he withdrew the remaining balance of the 401k and closed that account, the $13,000 that would have been paid back to that account is now considered a distribution. That distribution is subject to tax and penalties.
So now the entire account becomes taxable. The $50,000 and the previously borrowed $13,000 totaling $63,000 will be subject to taxes. Those tax liabilities will be close to $18,000 at the end of the year and remember $10,000 (20% of the $50,000 has already been withheld).
How To Avoid The 401k Mistake
To avoid the 401k mistake he needed to “roll” his old 401k into his new 401k or open a new IRA account to move the money into. Rolling his account means moving his money from company to company, instead of receiving it as a distribution into his checking account. This process could have been completed with no tax and no penalty. During the rollover, we would have paid back the $13,000 loan from his proceeds which would have also avoided tax and penalties.
How To Fix It
Because the client took a distribution rather than rolling those funds into a new 401k or IRA account they are on the hook for all sorts of penalties and taxes. Then they came to me to see if we can “fix it.” At this point in the client’s chosen path, there are going to be penalties and taxes no matter what. Due to waiting too long (past 60 days) the entire balance including the previous unpaid loan will be subject to penalties and taxes.
A Word of Caution
If you are thinking about taking a loan or making a withdrawal from your 401k, please, call a professional. The professional is equipped to know the IRS rules and regulations and will be able to advise you so you don’t take major losses at tax time. Having our team of professionals by your side to review your plan, keep you accountable, and answer any questions along the way- will help create, ‘Simple Solutions in a Complex World” For more of my blogs, click here.
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We are not permitted to offer, and no statement contained herein shall constitute, tax or legal advice. Individuals are encouraged to consult with a qualified professional before making any decisions about their personal situation. We are able to provide you with information but not guidance or advice related to federal benefits. Our firm is not affiliated with the U.S. government or any governmental agency. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and The Resource Center are not affiliated companies. The Resource Center, Inc. is an independent financial services firm that utilizes a variety of investment and insurance products. Distributions from tax-deferred retirement plans are taxed as ordinary income. Employers issuing a check in your name for a lump-sum distribution are required to withhold 20% toward federal income taxes, so you would receive only 80% of the total value. Early distributions are required to withhold 20% toward federal income taxes, so you would receive only 80% of the total value. Early distributions from employer-sponsored retirement plans and traditional IRAs prior to age 591/2 may be subject to 10% federal income tax penalty. This is a hypothetical example provided for illustrative purposes only; it does not represent a real-life scenario and should not be construed as advice designed to meet the particular needs of an individual’s situation. All investments are subject to risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. This content is provided for informational purposes only and is not intended to serve as the basis for financial decisions. 850143- 3/21