Let’s begin by making the generous assumption that no matter how old you currently are, when you retire social security will still be funded and you’ll be able to draw your share from it for the rest of your life. If all you have when you retire is social security, you’re not going to be able to keep your quality of life at the level it probably currently is at.
You need to have made retirement contributions throughout your life that were invested in the market and had time to grow. This is a concept that is generally accepted, though not fully understood, by the working populace. Unfortunately, what is also generally understood is that prior to reaching retirement you can often find hardship reasons to access your retirement money prematurely.
One of the biggest mistakes I see my clients make is taking distributions from retirement accounts because they needed the money right then and there. Now before I go any further, I’ll tell you verbatim what I tell every single one of my clients who does this:
“You have to do what you have to do.”
I get it, you’re in a bind and you must do something. However, a large portion of the time my clients have decided they needed to do the only thing they could think of. The beauty of Molen & Associates is you’re not alone in making financial decisions, you can call us and allow us to brainstorm and open up other potential opportunities. However, we’re not mind readers, we need you to keep us in the loop whenever you’re making an important financial decision. You don’t have to call just to say “Hi”, but you should be looping us in throughout the year.
To assist in bringing more clarity to this topic, I’ll give you a hypothetical situation that is by far and away the most common mistake my clients make when taking early distributions from their retirement accounts. To reiterate, I see almost this exact scenario at least 3-4 times per year.
John and Jane Smith both work and each has a 401(k) retirement account. John is in his early 40’s and Jane just turned 39 for the second time. They’ve had quite a few things come up in the past couple of years that have set them back financially. They’re only able to make minimum payments on their credit cards and feel like they’re not really getting ahead of their debt. Based on their financial circumstances they think the best option is to withdraw $50,000 from John’s 401(k) to help them get back on track. They know it’ll hurt the future growth of the retirement account but once they’re not paying off debts anymore, they can increase both of their retirement contributions moving forward. In the end it’ll even out for sure!
John signs all the necessary paperwork to affect the distribution. The 401(k) plan provider asks if John wants to withhold the taxes and tells him the federal minimum is 10%. John agrees to have the taxes withheld and so of the $50,000 distribution, $5,000 is sent to the United States Treasury and the remaining $45,000 is wired into their account. They use this money to get out of debt and both John and Jane just increase their 401(k) contributions. They feel good about their decisions and have a plan to recoup the losses moving forward.
Then John and Jane come to Molen & Associates to have their taxes done. They forgot to call me to let me know they were going to make such a distribution but since the 401(k) plan provider already took out the taxes, they assumed the distribution wouldn’t affect their tax return. After reviewing the Form 1099-R that shows the distribution I explain to them the reality. John and Jane are in a 22% tax bracket and the entire distribution is taxed at that rate. Furthermore, the distribution was taken prior to reaching the retirement age of 59 ½ which means it’s subject to the early withdrawal penalty of 10%. This 10% penalty is additive to the 22% tax rate for a grand total of 32%. What started as a $50,000 distribution with $5,000 in federal income tax withholding ends up with an effective tax of $16,000. John is visibly frustrated and asks me why the $16,000 wasn’t withheld from the distribution “Why did they only take $5,000?!”
The reality is the 401(k) plan provider doesn’t know your tax rate, they don’t do your tax return! They only know what the law requires, which is what they always recommend. 10% covers the penalty, but nothing more.
I now must explain all of this in detail to John and Jane and tell them they owe $11,000 (remember, $5,000 was already paid of the $16,000 in grand total tax that the distribution caused). They tell me that since paying off the debts they’ve had a few more struggles and they have a little bit more credit card debt again, not much but they were hoping their tax refund would help them pay it off. They’re in shock and angry at the plan provider for not giving them more information.
The reality here is had they called me, I would have done the same math and explained the outcome. Maybe John and Jane would’ve made the very same decision, taking the $50,000 distribution, but this time having them withhold $16,000 rather than just the $5,000. They would’ve only pocketed the $34,000 difference, which makes it a very expensive $50,000, but maybe it’d have been enough. They may have also made a different decision, such as debt consolidation loans or borrowing from the 401(k) rather than taking a straight distribution. You see borrowing from the account isn’t a taxable event and can get some cash in your hands without the nasty tax implications.
Instead, John and Jane owe $11,000 to the IRS and the only thing they can think of to pay this off is to take another distribution. I’m not even kidding, that is sometimes the knee-jerk reaction that this hypothetical John and Jane will have. Luckily right then and there they’re sitting in front of me and I’m able to guide them. You see, I don’t make financial decisions for my clients, I explain the outcome of all the possible decisions, advise them on what I think is the prudent course, and then tell them “You have to do what you have to do.” I just make sure they know what the consequences of their actions will be. I’ve mentioned this in some of my other posts, but I will again tell you that when I was young my mother taught me “frustrations only come from unrealized expectations.” and I’ve lived my life by that mantra. John and Jane were frustrated because they expected the $5,000 withholding to cover all the tax on their distribution. If they knew it was $16,000 from the jump and still decided to do it, then they would never have experienced that same frustration.
I hope this hypothetical situation was helpful in explaining some of the biggest mistakes I see regarding retirement distributions. If you’re considering taking a retirement distribution, please reach out to us at Molen & Associates. We’ll be happy to give you a free 15-minute consultation so your financial reality can match up to your expectations!
Tax Advisory Manager