IRA AND 401(K) WITHDRAWAL BLUES - DEALING WITH PENALTIES AND INTEREST
TAX LIABILITY WOES FROM 401(K) OR IRA WITHDRAWALS
Have you been forced to tap a 401(k) or other retirement account due to an emergency? Did you get bad advice from your accountant or advisor? Did you unintentionally take out money that caused a string of seemingly endless tax penalties you were not expecting? Did you fail to pay income tax on the receipt of the income, adding insult to injury?
You are not alone! This is one of the most common tax problems we see. We get calls every day about tax liability stemming from 401(k) withdrawals.
There are many types of IRAs: Traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEPs. With these plans, for 2014, you can shield up to $17,500 under the Federal governments Thrift Savings Plan by contributing it to such a plan. This is powerful stuff! That means you can defer about $8,000 of tax liability. However, with this gift come severe penalties for early withdrawal.
How is My Gross Income Calculated When I Make a Withdrawal?
Withdrawn IRA or 401(k) amounts are gross income that has not previously been taxed and it increases your Gross Income and hence your graduated Tax Rate for the year.
If you normally only pay 20% on your Gross Income due to the amount you earn, the distribution can propel you into the 38% tax bracket.
If you normally are in one of the upper-income tax brackets, amounts included due to an IRA withdrawal can cause you to now qualify for the Alternative Minimum Tax (“AMT”) and itemized deduction phase-out provisions.
The important point is that you can end up with a far greater tax problem than you ever could have imagined, far in excess of the 10% penalty.
What is the 10% IRS PENALTY?
Unless you fall in a very limited set of special categories, you are probably on the hook for the 10% early withdrawal penalty if you actually made an early withdrawal.
401(k) plans have preferential tax-deferred treatment. Withdrawals before age 59 ½ trigger a 10% penalty in addition to the income tax on the withdrawal unless:
- You make a qualifying rollover;
- You are totally disabled;
- You pay medical expenses exceeding 7.5% of Adjusted Gross Income;
- You receive unemployment compensation for at least 12 consecutive weeks and pay medical insurance premiums;
- You pay qualified higher education expenses;
- The distribution is $10,000 or less and use for qualified first-time home-buyer expenses;
- You received a qualified reservist distribution;
- The distribution is one of a series of annuity-type SEPP payments;
- You are a beneficiary receiving benefits on death of the owner; or
- The distribution was due to an IRS levy of the IRA.
Penalties on Penalties – Oh My! How You Can Owe Between 20% and 100% More than the Gross Income and Tax Received from the 401(k) Distribution
Let’s say you don’t report the additional income on your tax return, or confused what to do, fail to file a tax return. You may have your return audited or the IRS may file a return for you.
That’s right. The IRS will file a return for you based on your tax transcript if you don’t. Your 401(k) administrator will have reported the income to IRS. As a result you will end up with a deficiency. Unfortunately, you may also get dinged with additional penalties and interest.
In many cases you will be accountable for a 20% negligence penalty, a 40% gross negligence penalty and/or a 75% fraud penalty.
There are similar penalties at the State Level for the portion of State income tax triggered by the withdrawal as well as penalties and interest on those amounts.
It is a sad fact that in some cases, in a bizarre and unusual twist allowed by the tax enforcement provisions of the tax laws an unwitting taxpayer can take out $10,000 from a 401(k) in 2006 and end up owing federal and state tax authorities $25,000 by 2010 if affirmative action is not taken to correct the problem.
These snowballing characteristics of 401(k) troubles are another reason to be very careful with 401(k) and IRA tax problems and to begin taking care of them as soon as you find out about the problem and before the IRS gets a head start.
The IRS will be reasonable with you, but not if you bury your head in the sand.
What to do About Tax Liability from an IRA or 401(k) Withdrawal
IRS representatives also see these cases every day and understand the fact that taxpayers are confused by these byzantine provisions.
If you go to the IRS and don’t wait for them to come to you, you have a good chance of avoiding the penalties and interest that can turn an otherwise fixable problem into a nightmare. There are IRS provisions that allow a taxpayer who relied on an advisor and had reasonable cause for his failure to fulfill obligations to be relieved of penalties. Sec. 6664(c)(1); sec. 1.6664-4(b), Income Tax Rags. This involves telling one’s story and providing the facts to the IRS. The taxpayer must show he acted with reasonable cause as a prudent businessperson would, but fell into a trap for the unwary. See sec. 6664(c)(1); see also Higbee v. Commissioner, 116 T.C. 438, 446
(2001); sec. 1.6664-4(b)(1), Income Tax Regs.
Blaming Your Accountant Without More Is Not Enough – But It’s a Start
You don’t want to just blame your accountant or administrator. You need a more compelling story, but the law does consider this as a factor relevant to how the IRS will rule on the issues.
Good faith reliance on professional advice concerning tax laws may be a defense to the negligence penalty. Neonatology Assocs., P.A.v. Commissioner, 115 T.C. 43, 99 (2000), affd. 299 F.3d 221 (3d Cir. 2002); see also United States v. Boyle, 469 U.S. 241, 250-251 (1985); sec. 1.6664-4(b)(1), Income Tax Regs. However, “Reliance on professional advice, standing alone, is not an absolute defense to negligence, but rather a factor to be considered.” Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991); see also sec. 1.6664-4(b)(1), Income Tax Regs. In order to be considered as such, the reliance must be reasonable. See Freytag v. Commissioner, supra at 888; sec. 1.6664-4(b)(1), Income Tax Regs.
What Do I Do Now?
Your best bet is to hire a competent Tax Attorney who understands these rules, procedures and tactics to speedily resolve these issues with minimum fines and penalties and who can negotiate the best possible deal with the IRS.