401(k): Your Taxes, Your Money
Three examples of things that frequently get people into being audited by the IRS and/or being slapped with various taxes and penalties that they did not foresee:
- Withdrawing money from a Roth IRA “too early”
- Borrowing from your 401 (k)
- Not understanding the difference between a rollover and a transfer
Early withdrawal from Roth IRA
If you want to withdraw money from your Roth IRA you first need to ask yourself two things:
- Have I held it for a minimum of 5 years?
- Am I 59 ½ years of age or older?
If you can’t answer at least one of those questions with a yes, you need to be careful because the only way to make a penalty free withdrawal is to not take out any more than what you put in (which was deposited after you paid taxes).
Borrowing from your 401(k)
There are scenarios where borrowing from your 401 (k) can be a sound financial decision, but it is very important to inform yourself about the rules beforehand to avoid the pitfalls of 401(k) loans.
Typically, you will be allowed to borrow up to 50% of your 401(k) balance up to a maximum of $50,000. The loan must be repaid within 5 years, unless you get an extended repayment schedule because you used the borrowed money for a down payment on a home.
You can repay the loan through automatic deductions from your paycheck. N.B! If you don’t make a payment for 90 days, that money is considered a distribution and taxed as income, and if you are younger than 59 ½ years there will also be a 10% penalty.
Another thing that is important to know is that if employment is terminated (voluntarily or involuntarily) you must pay back the entire loan within 60 days – other ways you will incur those same financial penalties.
Interest payments on a 401(k) loan are not tax deductible.
Transfers vs. Rollovers
- If you move funds between like accounts, that’s a transfer. Example: You move funds from one Traditional IRA to another Traditional IRA. Transfers are not reported to the IRS, because you never take possession of your money.
- If you move funds from one eligible retirement plan to another, that’s a rollover. Example: You move funds from your 401(k) to a Rollover IRA. Distributions like this are reported to the IRS and may be subjected to federal income tax.