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Author: jmrut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 25316  
Subject: 401k withdrawal question Date: 12/3/2012 9:46 PM
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I'm trying to advise my friend that wants to take out all of her money from her 401k. She is only 55. She has an outstanding loan of 6000. The 401k balance it 13000.

If I'm correct, she will owe taxes on the 6k loan (and penalty) in addition to the same for the balance. Is this correct?

thanks,
rut
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Author: Fuskie Big funky green star, 20000 posts Top Favorite Fools Old School Fool Ticker Guide SC1 Red Winner of the 2010 Rule Breakers Challenge Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24952 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 12:21 AM
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In order to pay off her $6000 loan, she'll have to take out from the 401k not only the $6000, but also enough to cover the income tax on the total amount of the distribution.

Fuskie
Who notes she will have to have an idea of her tax rate in order to estimate how much extra she will need to withdraw in order to satisfy both the loan and the tax liability...

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Author: jmrut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24953 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 8:05 AM
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Thanks. She actually wants to withdraw everything so of the 13k left in the account she would automatically lose the 6k she borrowed and then have to pay taxes and penalty for 19k (6k loan + 13k balance) out of the remaining 7k. Is that correct? Basically there is nothing left is what I'm trying to tell her!

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Author: Fuskie Big funky green star, 20000 posts Top Favorite Fools Old School Fool Ticker Guide SC1 Red Winner of the 2010 Rule Breakers Challenge Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24954 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 11:09 AM
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If she is starting with $19k, you can generally factor in 40% in taxes and penalty, leaving $11,400. She would basically be throwing away over $7000, more than the balance of her loan, in order to pay off the loan.

Fuskie
Who missed earlier that she was not yet of age to take a penalty free distribution...

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24955 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 2:31 PM
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She actually wants to withdraw everything so of the 13k left in the account she would automatically lose the 6k she borrowed and then have to pay taxes and penalty for 19k (6k loan + 13k balance) out of the remaining 7k. Is that correct?

Not exactly. The money for the loan was already withdrawn from her account, so she won't have to "pay back" the loan with money from her current $13k account balance. It will just be considered a withdrawal. (This assumes that her employer will allow her to default on the loan, and won't require her to continue paying back the loan as long as she's still employed.)

Assuming that she ends up withdrawing everything including the loan, she will owe Federal taxes at her marginal rate (probably at least 25%, or almost $5k), plus a 10% penalty (almost $2k), plus state taxes and penalties, if required by her state. As an example, if she lives in CA, she would probably be in the 9.3% marginal bracket, plus owe a 2.5% penalty, which would total about $2.2k. So, all in, her taxes and penalties would be around $9k, so she would have about $4k left from her $13k balance.

However, when sending her the money, the administrator of the plan is only required to withhold 20% ($3.8k) for Federal taxes, and often not required to withhold anything for state taxes. So, she would potentially end up with a little over $9k from the withdrawal, and a $5k tax bill that would come due in April. If she's not disciplined enough to put $5k of the $9k away for taxes, and NOT TOUCH IT, she's likely to be in much deeper trouble than she is now. And the IRS and state taxing authorities are not good creditors to have.

As far as her being 'only 55' - I presume you meant this in referring to her being exempt from the penalty. However, at 55, if she has little/no other retirement money set aside, she actually has very little time to replace this $19k before she actually retires.

I can think of very few reasons that it would be a good idea in the long run for her to take the course of action that she's proposing - possibly life-saving medical treatments (although those may be able to be put on a payment plan) or paying off a tax lien (although that may also be able to be put on a payment plan).

AJ

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24956 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 2:42 PM
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In order to pay off her $6000 loan, she'll have to take out from the 401k not only the $6000, but also enough to cover the income tax on the total amount of the distribution.

Sorry, this is not correct.

The money for the loan was already taken out of her account, so the only way that she can 'withdraw' the loan balance is to default on the payments. The question is - assuming she's still employed, will her employer allow her to stop taking those payments out of her paycheck so that she will default?

Also, if she were to withdraw the $13k and use some of the $13k to pay back the loan, she would now have a $6k balance in her account, and would not owe taxes or penalties on the $6k - just on the $13k. She would have to initiate another withdrawal to withdraw the $6k if she wanted that money out of the plan. Since plans often have pretty stringent rules about withdrawals, she may have to wait 6 months - 1 year (or more) in order to initiate that 2nd withdrawal.

AJ

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Author: jmrut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24957 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 4:51 PM
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THanks for the reply. I wasn't suggesting she would lose another 6k from the 13k she still has, only that she would have to pay the taxes and penalty on the 6k loan (assuming default) in addition to the taxes and penalty for the 13k when that is withdrawn.

She is now retired so I don't know how that affects the ability to default on the loan.

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24958 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 9:13 PM
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She is now retired so I don't know how that affects the ability to default on the loan.

If she retired from the employer who held the 401(k) in or after the year she turned 55, there will not be a penalty to pay on the 401(k) - at least from the Federal level. State penalties may also be waived, if the state follows the Federal rules.

So, if she is making payments on the loan on her own, she could default by stopping payment on the loan. If the payments are from a payment that she gets from the former employer, they may or may not let her default.

AJ

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Author: jmrut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24959 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 9:18 PM
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She is actually a retired teacher. She retired Dec 31, 2011. Why would that keep her from having to pay penalties on the loan or did I misunderstand?

Rut

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24960 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 9:33 PM
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In 401K plans, if you leave your employer after Jan 1 of the year in which you turn age 55, you may take distributions without paying the penalty. The distributions are taxed as ordinary income, but penalty free.

So if she turned 55 in 2011, her distributions should be free of penalty (but spreading them over several years might keep her in a lower income tax bracket).

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24961 of 25316
Subject: Re: 401k withdrawal question Date: 12/4/2012 10:01 PM
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She is actually a retired teacher. She retired Dec 31, 2011. Why would that keep her from having to pay penalties on the loan or did I misunderstand?

When did she turn 55? If she turned 55 in 2011, it would keep her from paying penalties on any of the withdrawal, not just the loan.

There is an IRS rule that allows withdrawals from a 401(k) to be penalty-free if one leaves the service of the employer sponsoring the 401(k) in or after the year one turns 55. Unfortunately, my guess is that she retired 1 day too early to take advantage of this, since she probably turned 55 in 2012, but retired in 2011. That means she will owe penalties on any withdrawals until she reaches 59 1/2.

AJ

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Author: jmrut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24962 of 25316
Subject: Re: 401k withdrawal question Date: 12/5/2012 8:52 AM
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Yep. She turned 55 in 2012 but the loan was taken out in 2011. Guess she owes penalties if she goes down this path.

Thanks for the info.

Rut

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Author: aj485 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 24963 of 25316
Subject: Re: 401k withdrawal question Date: 12/5/2012 9:50 AM
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She turned 55 in 2012 but the loan was taken out in 2011.

Again - it's not the date of the loan. The critical factor is that she RETIRED in 2011, while she turned 55 in 2012.

Guess she owes penalties if she goes down this path.

Yes, since she turned 55 in 2012, if she had retired in 2012, she would still owe taxes on any withdrawals (loan and/or account balance) but would not owe any penalties. Since she retired in 2011 and turned 55 in 2012, she is now subject to penalties for all withdrawals (loan and/or account balance) until she is 59 1/2.

AJ

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