The Danger of Retirement Plan Distributions

The Internal Revenue Service is considered to be the toughest collection agency in the world. Revenue officers are trained to be real killers when it comes to collecting unpaid taxes. When a taxpayer is contacted by a revenue officer, the officer’s primary objective is to determine the balance due, collect all of the balance due and collect it as quickly as possible.

One of the easiest ways to develop a relationship with a revenue officer is for a taxpayer to cavalierly treat their retirement distributions.

Of most importance is the fact that plan administrators will normally only withhold 20% of the federal tax (unless told to do otherwise). Sometimes, nothing is withheld. Currently, with upper graduated tax rates of 25% through 39.6%, the 20% withholding may not be enough to cover the actual amount due. Plus, many taxpayers forget to consider the effects of state taxes.

Secondly, some folks are under the impression that some or all of their distributions are tax-free. Unless the plan is funded with after-tax cash, typically associated with Roth IRAs and Roth 401Ks, the tax on the balance (including pre-tax contributions and investment growth) is tax-deferred, not tax-free. Tax-free means there will never be a tax on the withdrawal. Tax-deferred means the tax is put off until a later date.

Lastly, the other consideration that is often lost is the 10% penalty for taking a distribution before you reach the age of 59½.  This penalty is actually treated as a surtax (an additional layer of tax), unlike other tax penalties that are subject to abatement or cancellation for reasonable cause. However, there is a list of exceptions to the 10% penalty that are shown within Internal Revenue Code 72(t) that taxpayers should consider before paying this amount.

So, with all that being said, let’s say a taxpayer, who is 50 years old, single and living in Florida, requests a retirement plan withdrawal on January 5 of $300,000 and has 20% withheld ($60,000), so that the net cash received by the taxpayer is $240,000. When the taxpayer prepares their tax return the following April, assuming there is no other reportable taxable income, the total liability will be approximately $80,000 (effective actual tax rate of 26.67% * $300,000). With the withholding of $60,000, there will be an initial amount due of $20,000 on the return. Assuming none of the IRC 72(t) exceptions apply, the 10% penalty will be $30,000. So, a grand total of $50,000 is due. If the net cash received has all been spent due to lifestyle expenditures, payoff of debt, vacations, etc., the taxpayer will suddenly experience that “Oh S---“ moment.   

What to do? In many instances, taxpayers will panic and not file their tax returns. Not a good move. For one, the IRS will eventually hunt you down. Two, the non-filing penalties can be onerous. The tax authorities can be somewhat forgiving when not paying your taxes. They have very little, if any, mercy when dealing with non-filers. So do yourself a solid: Don’t be one. There are several payment options that can be considered such as installment agreements, offers-in-compromise, and being placed in ‘currently not collectible’ status.

Beyond all the tax research materials available online, there is no substituting the counsel of a competent tax professional. When contemplating a transaction, such as the one above, it is always wise to seek advice from someone who has your best interest in mind and can guide you around the tax minefields. If you wait until after entering into a major transaction to seek tax help, the help usually comes in the form of damage control. You will find that professional fees between the two approaches will be drastically different.