Broker Check

On Penalties for Lump-Sum 401(k) Withdrawals

Howard Hook, CFP®, CPA, quoted in The Star Ledger's business column, "Biz Brain" on February 5, 2012

Question:  It's easy to figure out the overall percentages of tax penalties for early withdrawal of 401(k) funds for people less than 65 years old, but what sorts of penalties exist for lump-sum 401(k) withdrawals when the person is over 74 years old? My mother, 74, withdrew $75,000 from her 401(k) to pay for a house outright. She's now terribly afraid of the taxes that she will owe. Can you please give some guidance in this matter? — Trying to help

Answer:  There's not much your mom can do about taxes, but she won't have to worry about any other kinds of penalties for the withdrawal. Whether or not she will have to pay taxes, and how much, will depend on the details of her situation. There are other issues she needs to be aware of, though.

“A $75,000 distribution from your mom's 401(k) will make her Social Security benefits taxable,” said Gail Rosen, a Martinsvillebased certified public accountant. “The law states that if her income is above $34,000, 85 percent of her Social Security benefits would be taxable. If her income is between $25,000 and $34,000, up to 50 percent of benefits are taxable. The income that is used in this formula is combined income, which is adjusted gross income (AGI) and non-taxable interest, and one-half Social Security benefits. There are some others that can count towards this but may not affect your mom. In the future, if she has a choice of when to take out a distribution from a retirement account, careful tax planning can save money, such as taking distributions out over time versus all in one year.”

Rosen also said this is the year to try to bring down your mom's income by going through all of her expenses that might be deductible. Do not forget to look at her medical expenses, medical miles at 23.5 cents per mile for 2011, charitable donations, charitable miles at 14 cents per mile for 2011 and donations of household goods and/or clothing to charitable organizations.

For those Brainers who are also considering such a withdrawal, keep in mind that those under 59 1/2 will generally pay a 10 percent penalty on top of the taxes owed. There are some exclusions to the penalty, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

“The most common exclusions to the early distribution penalty include distributions due to death, disability, separation from service after reaching age 55 – though that doesn't apply to IRAs – and [withdrawals for] medical expenses in excess of 7.5 percent of adjusted gross income. Hook said people who are under age 59 1/2 often think that if they qualify under one of the exceptions mentioned above that they do not have to pay the tax. “There are no exceptions to paying the tax,” he said. “The exceptions only relate to eliminating the 10 percent penalty.”

And while those taxes are painful, remind your mom that she's enjoyed years of tax-deferred growth on the account. That's something, at least.