Early tapping of 401(k) brings woes

Taxes, penalties, loss of tax-deferred growth can be painful result

Dollars & Sense

April 08, 2001|By Liz Pulliam Weston | Liz Pulliam Weston,LOS ANGELES TIMES

Last week, my husband withdrew $20,000 from his 401(k) plan to help pay off a debt. As things turned out, the withdrawal was unnecessary.

The silly man did not think to check with me, and I had another resource to cope with the need.

He forfeited about $4,500 in penalties and prepaid taxes on the amount he withdrew. Can he redeposit the withdrawn amount and not be subject to the tax? Is there a time frame within which such redeposits may be made without penalty?

The silly man, indeed. He risked forfeiting a heck of a lot more than $4,500.

Early withdrawals from 401(k) plans are subject to 10 percent federal penalties, plus state penalties. Worse yet, you would have to pay income taxes at your regular rate, which means you typically lose half of what you withdraw to penalties and taxes.

Worst of all, you're giving up the future tax-deferred growth of that money - and that's an awful lot to lose. A $20,000 withdrawal means giving up $100,000 or more in future income, assuming the money would have grown tax-deferred at a 9 percent annual return for 20 years.

That's why financial planners tell you not to touch retirement funds unless the wolf is not only at the door, but in your kitchen frying himself a steak.

Whatever short-term need is solved by such withdrawals is almost always outweighed by the long-term costs.

Fortunately, there is a solution. If your husband deposits the $15,500 he has left into an individual retirement account, and then adds $4,500 (to replace the amount that was withheld), he can avoid the taxes and penalties completely.

He should get the $4,500 back when the two of you file your income taxes.

If he can't come up with the additional $4,500, you'll have to pay taxes and penalties on that amount. It's better than having to pay taxes and penalties on $20,000, of course.

It's best to hurry. For this to work, the money needs to be deposited into an IRA within 60 days of the withdrawal.

And now that you have had this experience, make a pact not to touch your retirement money without consulting each other and a qualified tax adviser.

The stakes are too high to risk a bad move - even a well-intentioned one.

I have been reading a lot about how to calculate the amount of income I need for retirement.

The usual calculations indicate that I should plan on getting 70 percent to 80 percent of my current income at retirement. That seems a bit high if my mortgage and car are paid off by then.

Is there a better rule of thumb for calculating my target retirement income?

Here's another one of those open secrets about financial planning: Nobody knows how much money you're going to need.

Financial planners say aiming to have 70 percent to 80 percent of your gross income at retirement is a good benchmark for most people.

If, as you say, your debts will be paid off, you might need less. But if you like to travel or have other expensive hobbies, you might need 90 percent, 100 percent or even more, at least in the early years. (Most people tend to spend less as they age.)

What you'll actually need, though, is anybody's guess. Nobody can predict what inflation will be next year, let alone in the many years until your retirement and afterward.

You can't predict what the markets will do or what changes might come in your life that could affect your spending.

As you get closer to retirement, you can make better-educated guesses. For now, however, it's probably smart to stay on the conservative side with your calculations.

Most people find it's better to have too much money in retirement than too little.

Last year we started taking monthly withdrawals from our individual retirement accounts. My wife and I are over 60. Needless to say, the overwhelming majority of the mutual funds in our IRAs lost money.

Are these losses deductible on our taxes this year?

Nice try, but no dice. Losses in tax-deferred retirement accounts aren't deductible.

That makes sense if you think about it. You didn't have to pay taxes on your gains during all those years that the stock market was booming, so why should you get the tax benefit of a deductible loss now?

The trade-off for sheltering money in a tax-deferred account is that your withdrawals are taxed at ordinary income tax rates. (The exception is the Roth IRA, which allows tax-free withdrawals in retirement.)

If you want to use your losses to offset your gains, you must invest outside a retirement account.

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