Adventures in Taxland, Part II

I have done the taxes for a couple of people who cashed in their retirement plans so far this year. Let me tell you, from a tax perspective it is a really bad idea.


I had a client this weekend who pulled all the money out of her 401K plan. First of all, the IRS considers 100% of that to be current income. The real whammy, however, comes from the 10% penalty tax. This penalty is applied even if you have no taxable income.

For example, let’s say you are a single parent of two kids with $9000 of earned income, combined with closing out a 401K worth another $9000. With a Head of Household standard deduction and three personal exemptions, your taxable income is reduced to $0. You get all your withholding back, plus Earned Income Credit, plus Additional Child Tax Credit. But the penalty tax of $900 is applied anyway, reducing your refund by that amount.

For this weekend’s client she got the double whammy. She cleaned out her 401K, and thought she had protected herself by withholding 20% of the money. But there was enough money in the 401K account to double her income for the year. What that increase did was push her into a higher tax bracket. She was in the 25% bracket for almost all of the retirement money. So instead of withholding 20%, she should have withheld 35%.

Let’s add up the damage:
• She had to pay in an additional $1100 to the IRS due to the unplanned tax liability.
• A third of her money was lost before it ever hit her bank account.
• And the real kicker: she doesn’t have a retirement fund anymore.

For low income individuals, the temptation to tap into the pot of money represented by a retirement account is pretty strong. But the results of giving in to that urge are never pretty.