Tax snare set for retirement funds PERSONAL FINANCE


January 31, 1993|By JANE BRYANT QUINN | JANE BRYANT QUINN,1993, Washington Post Writers Group

New York -- To improve its money flow, Congress has passed a tax-collection law that will be unfair to a lot of people. It touches everyone who might withdraw money from an employer-sponsored, tax-deferred retirement plan.

Don't get me wrong; I'm all in favor of rules that will capture every dime that taxpayers owe. But this law can entrap you, by creating a tax liability where none had to exist. Even worse, it raises money only from the ill-informed. The well-informed will know how to avoid it.

U.S. Rep. Jan Meyers, a Kansas Republican, has introduced a bill to repeal this unwise law. All fair-minded people should write to their senators and representatives in support of the bill.

The new provision applies to most withdrawals from employee retirement plans, such as 401(k)s. The easiest way to explain it is to give an example.

Assume that you have $20,000 in your 401(k) plan and leave your company for a new job. If you request that $20,000 in a personal check, as is often done, your company can now give you only $16,000. Exactly 20 percent -- $4,000 -- must be withheld for income taxes.

But what income taxes? You won't owe a tax if -- within 60 days -- you roll your 401(k) distribution into an individual retirement account or into your new employer's retirement plan. In that case, you can get your $4,000 back, by claiming it as a refund on your tax return. What does the government get from this deal? The temporary use of your money, interest-free.

But the government has an ace up its sleeve. To avoid paying taxes, you have to roll over the entire 401(k) distribution -- which -- in this example is $20,000. Since your company gave you only $16,000, you have to find $4,000 somewhere else. If you can't raise the money (or didn't know you had to), that $4,000 will be treated as a taxable withdrawal.

So you'll owe a tax. On a $4,000 withdrawal, you would owe $1,520 in the 28 percent bracket (counting the 10 percent penalty for funds withdrawn before age 59 1/2 ). You will also be liable for state and local income taxes.

Those who support the new tax-withholding law point out that it's easy to avoid. All you have to do is tell your employer to transfer your 401(k) funds directly into an individual retirement account, or into the retirement plan of your new employer. In that case, no taxes will be withheld.

Unfortunately, not everyone will get the message. Some employees will err and be caught in the tax trap.

Under the law, your employer must give you a written explanation of your choices, at least 30 days before you take the money.

But my associate Amy Eskind reviewed some of the memos employers are putting out and found a mixed bag. Some are clear and direct and will help people reach the right decision. Others can only be called opaque.

I saw one especially good idea, from Continental Insurance in New York City. Continental set up an interim IRA at Metropolitan Life. If an employee isn't sure where to transfer his or her money, it can be wired to Metropolitan; at a later date, those funds can be transferred somewhere else. Both of these transfers can escape tax withholding.

You can also set up your own interim IRA, ideally at a money-market mutual fund or bank money-market account. That keeps your money safe while you're thinking about where to invest it long term.

The 20 percent income-tax withholding is not levied on %o withdrawals set up as lifetime annuities or on installment payments lasting 10 years or more. But taxes will be withheld from "hardship" withdrawals, for things such as medical payments or college funds.

When you cash any money out of the plan, you will owe income taxes and perhaps penalties for that year. So you might not mind the tax withholding. But I worry about those who intend to roll over the money tax-deferred and don't get the message on how to do it right.

Representative Meyers' bill would restore the old rule: no mandatory tax withholding. Then, no unlucky soul would pay taxes by mistake.

(Jane Bryant Quinn is a syndicated columnist. Write her at Newsweek, 444 Madison Ave., 18th Floor, New York, N.Y., 10022.)

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