“When you do the things in the present that you can see, you are shaping the future that you are yet to see.” ― Idowu Koyenikan
A few months ago, I was a guest on Chicago’s Intellectual Radio. The show’s host invited me to discuss taxes and strategies available to the average taxpayer as we approached the beginning of yet another tax season. One of my closing suggestions while on the show was for every taxpayer to strongly consider speaking with or seeing their tax professional at least on a quarterly basis…to which one listener replied with a one-word question – really?
By tax professional, I mean an Enrolled Agent, a Certified Public Accountant (CPA), or a Tax Attorney. Anyone with lesser credentials may or may not be able to offer appropriate guidance depending on their level of expertise.
Why (you may ask; like the curious listener) should I speak to my tax professional several times a year? Because life happens all year and those events associated with the many transitions our paths take have tax implications of which you need to be aware. Communicating with your tax professional during the year and addressing questions and concerns presently – while it’s happening, can prove to be a wonderful strategy in guarding against pitfalls of the future.
Take this into account…
…Summer is upon us, have you thought about taking money out of your retirement account to fund a project or an event?
Have you considered the tax implications of such a transaction?
Taking money out of your retirement account prematurely is the number one infraction I witness during tax season without question! Many taxpayers run low on the cash (especially in the summer and fall) they need to fund home projects, relocation efforts, medical bills, family vacations, new businesses, etc. The decision to remedy the problem is almost always taking money prematurely out of their retirement nest egg. The problem is, if you have not reached 59 ½ years of age, you will sustain a severe penalty for the distribution. Please understand you will be taxed on the entire amount of the withdrawal! This is chiefly the one thing most taxpayers don’t understand. Most rest easy, as they complete the paperwork for the early distribution, in the fact that 20% of the requested amount will be withheld for tax purposes. While this is a move in the right direction where tax planning is concerned, it does not satisfy the entire tax liability for the transaction in many cases.
Based on tax law, two major things work against the premature distribution of retirement monies. First, as mentioned above you are taxed on all the money you take out at your effective tax bracket. For instance, let’s say you withdraw $50,000 from your 401k, you will be taxed on $50,000 not on the $40,000 you received after the 20% withholding (20% of $50,000 = $10,000; $50,000-$10,000=$40,000). If you figure you are in the 24% tax bracket, your tax on this distribution is $12,000 (24% of $50,000). Second, there is a 10% additional penalty assessed on the entire amount withdrawn, that comes to $5000. So, all in all your entire tax bill for this withdrawal is $17,000 ($12,000+$5000). However, remember you did have 20% withheld which helps but does not alleviate this terrific tax bill…your balance then would be $7000 ($17,000-$10,000) and in the end, your effective tax rate for this transaction is a whopping 34%! Therefore, many of you who do not engage in tax planning by contacting your tax professional before the transaction, are left with an ugly tax amount due to the IRS and possibly the state.
Please stop here and make a decision to call your tax pro before tapping into your hard-earned retirement account.
This can all be avoided if you simply borrow (if allowed) from your retirement plan instead of taking an early withdrawal. Borrowing allows you to withdraw much of what you may need (in many cases 50% of the account value) without having to pay taxes or penalties on the amount. Your loan can be paid back in monthly deductions from your paycheck over a period of 5 years at a small rate of interest (typically 3-4%), all of which you pay yourself back by the deductions going right back into the retirement plan for your benefit. That said, provided there are no missed payments and no job loss, there is no 20% withholding, no tax bill, & no 10% penalty, For short-term loans where you need the money fast, this is a very viable option.
This is why you need to speak with your tax professional.
Gently related, here is a true account of a taxpayer who did not know the importance of contacting a tax professional before deciding what to do upon embarking on a major life event. Recently, I met a young lady who inherited a sizeable estate from her aunt. A Thrift Savings Plan was bequeathed to her to the tune of hundreds of thousands of dollars. Because she did not get any professional direction and was working against the clock, she made a quick decision to transfer the funds to her personal account. This generated a taxable event and ultimately, she was met with a huge tax bill. Within minutes of chatting with her, the direction she needed was assessed. She should have rolled over all funds to an inheritance IRA (her only option as qualified accounts go). This step would have afforded her the opportunity to avoid any taxation.
Therefore, tax planning is of the utmost importance and why you want to seek the advice of your chosen professional during the year, not just during the tax season while tax preparation is underway. I advise quarterly consultations, if nothing else, you and your tax professional can catch up on what has happened in your life for the last three months. The sharing may reveal some possible tax exposure…really.
Carla Madison, EA
Madison Financial Solutions, LLC
773-239-6100
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