Avoid These 3 Costly Retirement Tax Penalties

07.26.2016 3 Retirement Account Penalties Header ImageRetirement might seem like it should be all golf carts and leisurely lunches, but making the transition work for your finances can be a challenge. Unfortunately, many retirees find themselves paying taxes and penalties on decisions they didn’t think were all that important — until it was too late.

Let’s take a look at 3 common tax mistakes and how you can make sure to avoid them.

Taking retirement money too soon

Even if you retire early, you cannot take a penalty-free withdrawal from your 401(k) or IRA before you reach 59½. The 10% penalty you’ll pay is in addition to any taxes that might be owed on the withdrawal, making this one costly error.1

Of course, there are exceptions to the rule — for example, if you are disabled or have certain medical costs that you need help covering. However, the rules may vary depending on whether you have a 401(k) or IRA, so be sure to consult with a financial advisor or accountant.

For everyone else, remember that retirement planning is a long game: if you want to maximize your chances of long-term financial stability, seriously consider whether you want to pay such a steep price for cash today.

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Retiring with a 401(k) loan

Generally speaking, 401(k) loans should be a last port of call if you need money. One key reason: if you leave your job, your loan may become fully payable right away.2

Unfortunately, retirement can trigger the same issue — and more.

If you don’t pay your loan back on time, you’ll not only have fees and taxes on the loan amount to contend with, but also the specter of the 10% early withdrawal penalty. Not only that, but you might be paying the loan back with other income — on which you paid taxes.

It just adds insult to injury.

401(k) loans are risky for other reasons. For example:

  • They can be costlier than they appear due to complicated fee structures
  • Even if you stay at your job, you might still pay penalties if you don’t pay the loan back within a certain period

Most importantly: all that time your 401(k) loan balance was being used for something else, it wasn’t helping your nest egg grow towards retirement. Taxes or not, that’s a costly planning problem.

Forgetting the RMD

It’s not just early retirement financial decisions that get people into trouble.

Keep in mind that if you have a Traditional IRA or 401(k), you are obligated to begin taking Required Minimum Distributions (RMDs) from your account at age 70½.3

The specific amount you’ll need to withdraw is calculated using your account balance and your age (that is, your life expectancy). You can find out what you need to withdraw by using any number of online calculators or by speaking to a financial advisor, who can help you plan and process the transaction.

But whatever you do, don’t overlook the importance of the RMD.

The cost of forgetting an RMD makes the 10% early withdrawal penalty look like pocket change: you’ll pay a 50% penalty on the amount you should have withdrawn if you fail to take your RMD within the time limit.

While the IRS is willing to give leeway under specific circumstances (death, disability, etc.), even then it looks for the situation to be rectified promptly and accurately.

In other words, don’t get too comfortable keeping your finances on autopilot if you have an IRA or 401(k) — you have an important date with your RMD!

Keeping it together

Retirement is exciting, but it can also be complicated.

Taxes are just one aspect of retirement financial planning — but it’s important aspect to get them right. Start by keeping track of when you can start taking income, when you have to take income, and managing (or avoiding) any 401(k) loans.

And remember, if you’re unsure about how to handle a specific planning situation or are concerned about your tax bill, it can be very helpful to speak with a financial advisor.

Let Us Help!

We can discuss this topic and more in person at a complimentary appointment. As a bay area retirement specialist we can give you a review and make suggestions based on your retirement objectives.

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Important disclosures:

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by United Planners.

To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk.

Neither diversification nor asset allocation can ensure a profit or prevention of loss in times of declining values. United Planners does not render tax advice.

1 This section: Internal Revenue Service, “Tax Rules on Early Withdrawals from Retirement Plans.” August 4, 2015. https://www.irs.gov/uac/newsroom/tax-rules-on-early-withdrawals-from-retirement-plans

2 This section: The 401(k) Help Center, “401k Plan Loans – An Overview.” http://www.401khelpcenter.com/loans.html#.V50dtSOAOko

3 This section: Internal Revenue Service, “Retirement Topics – Required Minimum Distributions (RMDs).” https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds