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By: Ted Benna Creator of the first 401(k) plan |
May 2, 2002
This Week, Ted Tackles:
I withdrew $200,000 from my 401(k) to build a retirement home. How are the taxes on that calculated? ý Is it a good idea to take a 401(k) withdrawal to pay for my son's college expenses? What penalties are there? ý Should I consolidate my bills with a 401(k) loan? ý What information must employers report to employees concerning their 401(k) contributions and investment performance?
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Q: I am 62 years old, married and still employed. Our
joint income is $95,000. My wife and I withdrew $200,000 from our 401(k) this year in
order to buy land and start building our retirement home. Does this mean that we owe taxes
at a $295,000 income tax bracket or is the $200,000 we took out to build our home taxed at
a lower level? When we took out the money, the mutual fund company said it would take out
the necessary taxes for early withdrawal but apparently did not take out enough.
TB: The entire distribution ($200,000) is added on
top of your regular taxable income ($95,000) resulting a total gross income of $295,000.
The amount of tax you owe is computed on this amount after subtracting your deductions.
The 10 percent early distribution penalty tax doesn't apply
in your case because you are over age 59 1/2. Distributions after 59 1/2 are exempt from
this penalty tax even though you are still employed.
What likely happened in your case is that the fund company
deducted the 20 percent minimum withholding required by the IRS for such withdrawals. This
amount was credited towards the tax you ultimately must pay. It is impossible for the fund
company to withhold the exact amount because it doesn't know the rest of your annual tax
picture. Your actual tax liability is determined when you file your tax return. Even with
paycheck withholdings you may often discover during the tax filing process that you either
overpaid or underpaid your taxes.
Unless you had a lot of deductions, the total tax payable
on this distribution would be in excess of 30 percent, or more than $60,000. If the fund
company withheld only $40,000, at least an additional $20,000 will be due when you file
your tax return for this year. It may be advisable to pay additional taxes during this
year to avoid under-withholding. I recommend consulting with a tax advisor.
The fact that you will probably have to pay at least
$20,000 of additional taxes on this distribution may be an unpleasant surprise. Hopefully
other readers will learn from your experience. Be sure you know how much tax you will
actually have to pay before you take a taxable withdrawal from your retirement account.
Q: My son will be starting college this fall. I'm
considering using funds from my 401(k) to pay for his education. Will there be penalties
to pay for withdrawing money for this purpose? Is this a good idea?
TB: It depends upon whether you borrow the money or
withdraw it. A loan isn't taxable when you get the money, but it is over the long
term as you repay it. Any amount you withdraw will be fully taxable right away and
a 10 percent early distribution tax will apply if you are under age 59 1/2.
The total tax on the withdrawal is likely to be in the 25
to 40 percent range in this case. Let's assume you need $10,000 for your son's tuition,
and that the total tax payable is 40 percent, including the penalty tax. You must withdraw
$16,667 from the plan to have $10,000 left, after paying the tax you will owe. Such a
withdrawal is a really big hit that could adversely impact your retirement savings.
Of course repaying a loan isn't a lot of fun either because
you must pay tax on the amount you earn before paying the loan.
I recommend considering alternatives other than withdrawing
the money from your 401(k), because of the high taxes and the fact that you will be eating
into your retirement fund. The message I am about to deliver may be hard for a caring
parent to hear, but unless you plan on working late in life, this is your only shot at
saving for retirement. Your son can pay for college with a variety of methods. He can
enroll in a work-study program. He can check out financial aid programs and grants. Maybe
a wealthy relative is willing to make a gift to your son.
When I was in your position, I used loans from my 401(k)
and other lower-interest loans available through banks for paying educational expenses.
Repaying the loans was difficult but I wasn't about to take the big tax hit that would
have occurred by withdrawing money from the 401(k). I also maintained my contribution
level at the 6 percent rate needed to get the full employer match during this period. By
the way, there were some years when I had to pay tuition for four children. Bottom line, I
recommend exploring all alternatives and then going with what will work best for you.
Q: Is it a good idea to consolidate your bills with a
401(k) loan?
TB: I am not a certified financial planner, so I
don't have that license to back my statements. I do have extensive experience watching how
folks manage their retirement savings, though. So, for what it is worth, here are my
observations.
The number one problem I often observe with consolidation
loans is that people who do this quickly get back into the same debt situation. They start
taking out many consolidation loans and that becomes a new financial burden. I would
recommend a consolidation loan via the 401(k) or otherwise only if you can
successfully change your spending habits. Here are a few suggestions on how to do that.
- Only maintain one credit card and pay the balance fully each
month. Cut up all the others and throw them away. Also cut up and throw away the one you
keep if you start to run up debt again.
- If you take a consolidation loan, your monthly payments will
be reduced. Take the difference between the reduced payments and your previous higher
payments and either pay off the consolidated loan over a shorter period or put this amount
into savings.
- Another strategy to change your spending patterns is to
control discretionary spending by establishing time barriers between the urge and the
purchase. For example, when you are tempted to spend more than $50 for any item that isn't
essential, wait at least 24 hours and carefully think about what you are doing and why.
Q: What kind of information must an employer report to
his employees about their 401(k) contributions and performance of their 401(k) accounts?
TB: Amazingly, the IRS requires employers to provide
very little information to employees. Your employer is required to give you a statement
annually showing your contributions. There aren't any mandatory requirements for reporting
investment results other than showing the amount of your gain or loss on your annual
statement.
In addition, your employer is required to give you a
summary plan description that outlines the rules governing your plan. While this doesn't
concern investments, it is a very valuable document to keep.
From a practical perspective, employers should provide
sufficient information for employees to pick their investments. Most employers maintain a
401(k) to help attract and retain good employees. It is smart for employers to provide
employees with enough information to pick their investments. Most employers provide a lot
more information to employees than what is required because they want to help their
employees save for retirement. Typical handouts include fund profiles, fund annual
reports, a summary of fund performance and possibly a fund prospectus.
Employers that want relief from fiduciary liability
available through the Department of Labor's Section 404(c) regulations are required
to provide sufficient information for employees to make informed investment decisions.
However, these regulations are voluntary -- employers don't have to follow them.
It is also difficult for an employer with a lot of
employees to determine what is adequate. The employees participating in the plan can range
from new entrants into the work force who have virtually no investment knowledge to highly
knowledgeable veteran investors with $100,000-plus account balances. Meeting the needs of
employees with such a wide range of experience is challenging.
I recommend reading this Web site as a way to educate
yourself above and beyond what your employer provides. The extra knowledge can't hurt.
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Ted Benna, creator of the first 401(k)
retirement savings plan, answers intriguing questions twice a month. With over 40 years of
experience as an employee benefits consultant, Ted is a nationally recognized expert on
benefits issues. He has authored three books, Helping Employees Achieve Retirement
Income Security, Escaping the Coming Retirement Crisis, and Tips for
Successfully Managing Your 401(k), and is President of the 401(k) Association. Ted is
a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and
comments have appeared in numerous publications, including The New York Times and The
Wall Street Journal. |
 Ted's Table Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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