When you begin contributing a 401K in the early years of your working life, you are saving for your ultimate exit from the workforce. Along the way, things happen that can put a glitch in those plans. Should that occur, and you begin to contemplate withdrawal of the hard earned money that you tucked away, look past your immediate need and look at the consequences that your decision can make on your future. The obvious, of course, is that you will have just that amount less for your golden years. The other, not so obvious is the IRS.
401Ks, ESOPs, TRESOPs, or whatever name they are called by your employer, refers to tax deferred ventures in which every dollar put into the vehicle is one less dollar available for Uncle Sam to tax you on. Sound good? Of course it is. The problem arises when you withdraw tax free money, it then becomes taxable. Now most everyone is aware (knows and understands) this part. The part that eludes everyone is that there is also a ten percent penalty charged in addition to your tax for the year. If you withdraw a significant amount, your tax and penalty can and will be significant. This does not pose a problem when the individual prudently planned for the tax and penalty in advance (in addition to having federal income tax withholding at a rate of 20 %, they changed their withholding on their Form W4 to cover any shortfall that might arise) to have it properly deducted from the proceeds and sent to IRS. If you didn’t, when you see the amount that you owe, or the reduced refund, you’ll wish you had.
Fortunately, the tax law built into the equation exceptions to the additional 10% penalty. (Of course, not the tax; you’re on your own with respect to that). In the event that you withdrew a significant amount of money, say $50,000, a steep penalty of $5,000 on top of what you would already owe is enough to give you a headache. But if you did not have to pay the full $5,000, say $2,500, is still bad but better than the full amount. These exceptions state that if you had a good reason, which is any of the reasons listed below that you used all or a portion of the proceeds for, then you will not have to pay the additional 10 percent penalty. Outstanding! Here are the exceptions:
1. If you retired and withdrew the funds in a lump sum at or after age 55.
2. If you retire and opt to receive the funds in a series of payments (annuity) made over your life expectancy or that of your beneficiary.
3. If you receive the funds as a result of your becoming permanently and totally disabled.
4. The funds were received as a result of your death.
5. If the funds were withdrawn and used to pay unreimbursed medical expenses subject to 7.5 % of your adjusted gross income. The balance would be subject to the 10% penalty.
6. If the funds were withdrawn due to a qualified domestic relations order (For example, a divorce decree that specifies that one party be paid a portion of the proceeds of the 401K)
7. If the IRS places a levy on the funds.
It will be up to you to identify on your Form 5329, Part 1, Lines 2 and 3, the amount that is not subject to the additional 10 % penalty, which is line 2 and on line 3, to correctly identify the exception that applies to you (Found in the Form 5329 instructions, page 3). Should you find at a later point in time that you paid the additional tax and you qualified for an exception, obtain Form 1040X, US Individual Amended Return and Form 5329 for the year in question.
You can find all the forms and instructions listed above at the IRS website, www.irs.gov or you may order them by phone by calling 1-800-829-3676.
