Individual retirement accounts and 401(k) plans share many features in common, but they also have subtle differences. Not knowing the nuances can raise a tax bill—sometimes by a lot.
Both IRAs and 401(k)s are tax-favored retirement accounts, and with the demise of traditional pensions people have turned to them to save for their golden years. At the end of 2018 such accounts held $16.3 trillion in assets, nearly triple the $5.6 trillion total in 2000, according to the Investment Company Institute.
But these accounts aren’t the same, and one upstate New York couple ran smack into an arbitrary difference that raised their tax bill 65%.
In 2015, Bahman Amadi and Lily Soltani-Amadi needed a bit more cash for a down payment on a house in a good school district. So Ms. Soltani-Amadi withdrew $6,686 from her 401(k) retirement plan.
The couple knew they’d owe some tax, but Ms. Soltani-Amadi says a plan representative told her they would avoid a 10% penalty because the payout was for their first home.
That advice was wrong.
Earlier this month, a Tax Court judge ruled that the Amadis owed the 10% penalty on their 401(k) withdrawal. That added $669 to their $1,028 tax on the payout.
“I didn’t know about different retirement accounts, but I trusted the representative to know what he was talking about,” says Ms. Soltani-Amadi. She is now a college mathematics professor and her husband is a physician, but at the time she was between jobs and her husband was in training.
The Amadis tripped over rules on early withdrawals for home buyers. Because tax-favored retirement accounts are supposed to be for retirement, the rules often impose tax and a 10% penalty on withdrawals before age 59½. Younger IRA owners who take out up to $10,000 to purchase a first home don’t owe the penalty, while younger 401(k) participants do.
The Amadis’ 10% penalty is a shame because there was a workaround.
Natalie Choate, an attorney and retirement-plan specialist with Nutter, McClennen & Fish, says that if the couple had done a tax-free rollover of the 401(k) payout into an IRA and then withdrawn it, they wouldn’t have owed the 10% penalty because the payout was from an IRA. Income tax would still be due.
“The IRA and 401(k) rules are full of these booby-traps, and they hurt a lot of smart people who aren’t retirement experts,” says Ms. Choate.
The lesson here is to double-check the taxes on retirement-plan moves, especially withdrawals. Here are more differences between 401(k)s and IRAs to know about.
Education-expense withdrawals. Payouts before age 59½ from an IRA that are used for higher-education tuition, books and other costs are exempt from the 10% penalty. Similar withdrawals from 401(k) plans incur it.
Savers considering an early withdrawal from a 401(k) for such expenses should look into transferring the funds into an IRA before taking the payout.
Required minimum distributions. Mandatory IRA payouts begin at age 70½ under current law, and the account owner has until April 1 of the following year to take the first payout.
With 401(k) plans, the deadline is April 1 following the year the worker retires or turns 70½, whichever is later—unless the worker owns more than 5% of the company providing the plan.
As a result, some older employees can roll over existing IRAs into their firm’s 401(k) plan and delay their 70½ deadline for IRA payouts. But the plan has to permit such moves, and not all do.
Age 55—59½ payouts. Savers don’t owe the 10% penalty on withdrawals from a 401(k) before age 59½ if they were at least 55 in the year they left their job. But a 10% penalty applies to IRA withdrawals before the owner is 59½, except for certain exemptions. See IRS publication 590-B.
This discrepancy poses a problem for some departing employees between ages 55 and 59½ who will need 401(k) payouts for living expenses. If the former employer insists they withdraw their 401(k) funds and then they roll the entire amount into an IRA, payouts before 59½ will incur the 10% penalty.
But if the departing employees withdraw a large lump sum to cover several years and roll over the remaining assets into an IRA, that could trigger higher tax brackets. A better move, if possible, is to leave funds needed before age 59½ in the 401(k) and withdraw them as necessary.
Borrowing. Many 401(k) plans allow participants to borrow from them. The interest rates can be lower, and the terms better, than with other consumer debt. However, mortgage lenders sometimes don’t allow a 401(k) loan to count for purposes of a down payment. This is why the Amadis withdrew their 401(k) funds.
By contrast, borrowing against an IRA is prohibited, and doing so will terminate the account.
Creditor protection. In general, says Ms. Choate, employer-provided plans such as 401(k)s are better shielded from creditors than are IRAs. For IRAs, creditor protection varies from state to state, and some federal protections have vulnerabilities.
She adds, “Bankruptcy lawyers work hard to pierce the protections for IRAs, and sometimes they succeed.”
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