Below are portions taken from the article WHAT EVERY CITIZEN NEEDS TO KNOW ABOUT RETIREMENT FUND DISTRIBUTIONS found in my October 2016 issue of Pilla Talks Taxes. The full article is available to Pilla Talks Taxes subscribers. More information on how you can become a subscriber.
I can’t count the number of times people have told me that the reason for their delinquent tax debt is that they took a retirement fund distribution and didn’t realize the extent to which it was taxable. They might claim that “withholding” was taken from the
distribution which they “thought was enough to pay” what they would owe. As it turns out, that was not the case. Often, no taxes whatsoever were paid on the distribution.
In one case, my clients took out about $350,000. The plan administrator withheld 20% for federal taxes (absent specific instructions from the client), and sent the remaining balance—about $280,000—to the clients. They then used the money for all manner of spending. They made substantial repairs to one child’s home. They spent money on an elaborate vacation for the kids and grand kids (about twelve in all). And, they paid off substantial credit card debt for themselves and their kids. At the end of the spree, the money was gone—all of it.
When their tax return was completed the following spring, they experienced the worst kind of sticker shock. As it turned out, the 20% withholding of about $70,000 was well under the federal income tax hit, which alone was about a third of the total distribution, not to mention the state tax obligation on top of that. Considering that the early withdrawal penalty (if applicable) on a typical retirement plan distribution is 10% by itself, the $70,000 of withholding was less than half the total tax on the distribution.
Why did this happen? And why does it happen so often?
It happens because too many people simply do not understand the essential tax consequences of funding and liquidating IRA
and 401(k) retirement plans. For this reason, a more detailed discussion of these concepts is in order.
Tax-free or Tax-deferred?
Many people are under the impression that their retirement plan distributions are tax-free. In most situations, that is just not the case. For example, in the case of a typical IRA or 401(k) plan contribution, the retirement plan is tax-deferred, not tax-free.
When I say the plan is tax-deferred, I mean that the tax consequences are not eliminated. Rather, they are put off until some future date.
Here’s how the system works. Under ordinary circumstances, when you are paid $1,000 as compensation for services, the money is taxed in the year you earn it. If you pay taxes in the 25% bracket, the $1,000 carries a federal tax burden of $250, leaving you
with after tax income of $750. Now suppose you invest the $750 in some kind of investment portfolio. All of the investment earnings, whether capital gains, interest or dividends, are likewise subject to tax based upon the nature of the income and your tax bracket.
Now suppose that you deposit the same $1,000 into your IRA retirement account. At that point, the $1,000 is an adjustment to your income. That is, you get a deduction for the money in the year it is deposited to the account. That saves you $250 in taxes in the year of the deposit. Moreover, as the $1,000 earns investment gains over the years, those gains are also not subject to tax in the year of the gain as long as the gain remains invested in the IRA.
So far, so good. But this is often the point of confusion. People often believe that because there’s no tax on the gains as they are earned over time, and because they got a deduction for the initial contribution at the time it was made, the account is somehow not taxed at all. And this is the source of the confusion between the concept of tax-free and tax-deferred.
Tax-free means there is never any tax on the transaction. An example would be the proceeds of a gift or inheritance. These items are never taxed to the recipient. If you get a gift from your mother of $10,000, that gift is never taxable to you. It may be subject to a gift tax owed by your mother, but it’s not taxable to you as the recipient.
On the other hand, as stated above, tax-deferred means that the tax is put off to some future date. The transaction is not free of tax, but rather, the tax is imposed at a later date based on actions that trip a tax obligation.
IRA and 401(k) Contributions
IRA and 401(k) gains and distributions are tax-deferred. You get a deduction for the contribution in the year it goes into your account (subject to certain limitations). As such, the contribution is not subject to tax in that year. However, when you take
the money out of the account as a distribution, the money is taxed as ordinary income in the year of the distribution. By that I mean the distribution is treated as if it were wage income in the year of the distribution.
As such, a $350,000 IRA distribution in a given year is taxed in that year as if the taxpayer received $350,000 of wage income from his employer. Even without regard to the actual wage income received during the year, the $350,000 would be at least partially subject to the 33% tax bracket. (Because the tax rates are marginal, the 33% bracket applies to income over $231,450 but under $413,350 in 2016).
Get help with Retirement Plan Distributions
“Why didn’t the IRA people tell me that?”
This is a question I hear over and over as people learn about the tax and penalty consequences of a retirement plan distribution. The answer is I don’t know why they didn’t tell you. I believe a common reason is that you, as the taxpayer, may not have asked
the right questions, or in many cases, didn’t ask any questions at all.
And more likely, I don’t believe retirement plan people ever stop to think whether you have balanced out all the consequences of taking the money. After all, it is your money and you can do what you want with it. Nobody, including the IRS, can stop you from taking a distribution for any reason you like—or for no reason at all. You simply have to pay the price when you do.
The better questions to ask are, “What have you done to educate yourself about the consequences of a withdrawal?” And knowing the consequences, “Have you properly provided for payment of the tax liability that grows from the distribution?”
You are responsible to know the consequences of a retirement plan distribution and to provide for the payment of the tax
from the proceeds of the distribution. The IRS has resources available to help with this. Three specific publications discuss retirement plans generally, retirement plan contributions, and retirement plan withdrawals. These include IRAs and 401(k)s. The publications are:
- Publication 590, Individual Retirement Arrangements
- Publication 590-A, Individual Retirement Arrangement Contributions
- Publication 590-B, Individual Retirement Arrangement Distributions
Beyond the IRS’s publications, there is no substitute for good counsel from a tax pro who is educated and experienced in the specific area of concern. It is always best to consult counsel before you take any action so that you can be guided in how to identify and handle the anticipated consequences. If you wait until after you take action to consult counsel, the advice very often at that point amounts to nothing more than damage control.
Consulting Members of my Tax Freedom Institute can help with these and other tax planning and enforcement issues.
To contact the Consulting Member nearest you, Click Here
Article taken from October 2016 issue of "Pilla Talks Taxes."
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