I do not speak finance.
December 10, 2010 12:42 PM Subscribe
You are not my accountant, but maybe you can answer my 401k/tax question, in EXTREME LAYMAN'S TERMS.
I have money in a 401k from my previous employer. I have thirty days to decide whether I want to get a check, roll it over, or leave it there. I'm considering the former two, but I have some questions:
- If I decide to just get them to write a check to me, I understand that they will take 20% of that, and that they I will have to pay tax (10%?). But in some places it seems like the 20% is taken out FOR the taxes, and then other times if says that I'd have to come up with a match to the 20% on my own to get that back? I don't get it! What are they talking about?
- Why, if I'm going to roll it over to a Roth IRA, do people recommend that you have the tax money on hand without dipping into the 401k cash?
Please, don't try to convince me to leave it there! It's something I am considering already. Thanks for the advice!
I have money in a 401k from my previous employer. I have thirty days to decide whether I want to get a check, roll it over, or leave it there. I'm considering the former two, but I have some questions:
- If I decide to just get them to write a check to me, I understand that they will take 20% of that, and that they I will have to pay tax (10%?). But in some places it seems like the 20% is taken out FOR the taxes, and then other times if says that I'd have to come up with a match to the 20% on my own to get that back? I don't get it! What are they talking about?
- Why, if I'm going to roll it over to a Roth IRA, do people recommend that you have the tax money on hand without dipping into the 401k cash?
Please, don't try to convince me to leave it there! It's something I am considering already. Thanks for the advice!
other times if says that I'd have to come up with a match to the 20% on my own to get that back? I don't get it! What are they talking about?
IANA-whatever, but I think one rule is if you take an early withdrawal and the financial institution withholds 20% for tax, and then you decide that you'd rather roll it over instead, you have to repay the 20% that the FI withheld... you have to make the account whole for them to re-invest it for you.
Could that be what they're talking about?
posted by cranberrymonger at 12:51 PM on December 10, 2010
IANA-whatever, but I think one rule is if you take an early withdrawal and the financial institution withholds 20% for tax, and then you decide that you'd rather roll it over instead, you have to repay the 20% that the FI withheld... you have to make the account whole for them to re-invest it for you.
Could that be what they're talking about?
posted by cranberrymonger at 12:51 PM on December 10, 2010
Typically the 20% the 401k withholds is tax, while the 10% you pay is a penalty for early withdrawal. I believe this same is true if you dip into the 401k cash to pay for the Roth IRA taxes.
posted by politikitty at 12:53 PM on December 10, 2010
posted by politikitty at 12:53 PM on December 10, 2010
By the way, your former employer might employ the services of a pension plan administrator, who can give you some specific advice about tax consequences... that is, if you don't get the answer here.
posted by cranberrymonger at 12:57 PM on December 10, 2010
posted by cranberrymonger at 12:57 PM on December 10, 2010
The 20% withholding is related to an indirect rollover (where your 401(k) provider cuts you a check, and then you re-invest it in an IRA within 60 days). More info here. Indirect rollovers are a pain. I highly recommend you do a *direct* rollover instead. In a direct rollover, the 401(k) provider cuts a check to the IRA brokerage firm. You never get the money in your non-retirement checking account so you don't need to worry about tax consequences or withholdings. To do a direct rollover, do *not* ask the 401(k) company to write you a check. Instead, call the firm where you hold (or plan to open) the IRA that you want to move the money into. They will tell you exactly what to do.
posted by phoenixy at 1:00 PM on December 10, 2010
posted by phoenixy at 1:00 PM on December 10, 2010
Best answer: 1) The 20% is a tax withholding. So at the end of the year when you file your taxes: (a) the 401k cash will count as your income, (b) the 20% will count as tax withholdings. Then depending on the rest of your financial situation (other income and witholdings, your tax bracket, as well as tax deductions), you may get some of this back. Essentially, the idea is that the contributions you made to 401k were pre-tax (you never paid taxes on them), and when you cash out, you are paying taxes on them.
The 10% is a penalty for cashing out, you lose that completely.
2) For rolling over to IRA, you have two options: (a) Traditional IRA, (b) Roth IRA. In case of a traditional IRA, oreofuchi is right. A traditional IRA is a pre-tax retirement investment as well, so the roll-over would be done without any taxes or penalties. However, you would have to pay income taxes when you start getting distributions from your IRA.
A Roth IRA, on the other hand, is a after-tax retirement investment. That is, you pay taxes when you put the money in the account. So you would have to pay income taxes if you roll the Roth IRA into 401K. If you get your institution to do a "direct rollover" (from one account to the other), there would be no withholdings. But, at the end of the year, when you file taxes, you would have to come up with the amount of income tax on the money you rolled over. If you don't have access to such cash, you can do an indirect rollover (You get the money and invest it in a Roth IRA within 60 days), then your 401k institution would do a 20% withholding, similar to option (1) and you would see if you can get some of it back when you file taxes.
The positive side of the Roth IRA is that once your money is in Roth IRA, it grows tax-free and you don't pay any more taxes when you start receiving distributions.
The difference between Traditional IRA and Roth IRA is when you get to pay the taxes. If you think your tax bracket will be lower now, it's better to choose Roth IRA. If you don't think you have the cash to pay now, or that your tax bracket might be lower when you retire (very difficult to know now), then a Traditional IRA would be better.
posted by tuxster at 1:07 PM on December 10, 2010
The 10% is a penalty for cashing out, you lose that completely.
2) For rolling over to IRA, you have two options: (a) Traditional IRA, (b) Roth IRA. In case of a traditional IRA, oreofuchi is right. A traditional IRA is a pre-tax retirement investment as well, so the roll-over would be done without any taxes or penalties. However, you would have to pay income taxes when you start getting distributions from your IRA.
A Roth IRA, on the other hand, is a after-tax retirement investment. That is, you pay taxes when you put the money in the account. So you would have to pay income taxes if you roll the Roth IRA into 401K. If you get your institution to do a "direct rollover" (from one account to the other), there would be no withholdings. But, at the end of the year, when you file taxes, you would have to come up with the amount of income tax on the money you rolled over. If you don't have access to such cash, you can do an indirect rollover (You get the money and invest it in a Roth IRA within 60 days), then your 401k institution would do a 20% withholding, similar to option (1) and you would see if you can get some of it back when you file taxes.
The positive side of the Roth IRA is that once your money is in Roth IRA, it grows tax-free and you don't pay any more taxes when you start receiving distributions.
The difference between Traditional IRA and Roth IRA is when you get to pay the taxes. If you think your tax bracket will be lower now, it's better to choose Roth IRA. If you don't think you have the cash to pay now, or that your tax bracket might be lower when you retire (very difficult to know now), then a Traditional IRA would be better.
posted by tuxster at 1:07 PM on December 10, 2010
If you have a current 401(k) account at a current employer, you may also be able to do a "roll-in" with no penalty. I recently did this and it was pretty easy.
posted by chesty_a_arthur at 1:10 PM on December 10, 2010
posted by chesty_a_arthur at 1:10 PM on December 10, 2010
Whatever they take out in taxes will be reflected on the 1099 that they give you. You will then file that along with your taxes so you end up paying your normal income tax on it. So if they take out too much or too little, you'll break even after your taxes. In addition to the taxes, you likely have to pay a fee if you get a check. My plan has a 10% fee, so yours may indeed be 20%. Ouch! Roll it over! Either way, call them up and get clear on the fee if you decide on a check.
posted by soelo at 1:17 PM on December 10, 2010
posted by soelo at 1:17 PM on December 10, 2010
Correction for one of my sentences --> So you would have to pay income taxes if you roll the 401K into a Roth IRA.
posted by tuxster at 1:18 PM on December 10, 2010
posted by tuxster at 1:18 PM on December 10, 2010
You should rollover the 401(k) to a traditional IRA unless you have the money in hand to pay taxes for a Roth conversion. If you don't have the money in hand for taxes, you will have to take some of the money out of the 401(k) for taxes and you will pay a penalty for that withdrawal because it is not qualified.
For example, assume you have $10,000 in your 401(k) and are in the 25% tax bracket. If you rollover the $10,000 to a traditional IRA, you will owe no taxes.
If you rollover into a Roth IRA, then you will owe 25% or $2500 in additional taxes when you file your tax return next April. If you withhold $2500 from your 401(k) in order to pay taxes, it is just the same as if you withdrew $2500 to spend on a car. That is a non-qualified withdrawal and you will owe a 10% penalty on that withdrawal or another $250. So now you have increased your taxes in April by $2750 instead of the $2500 if you paid your taxes out of hand. Further, you now have a Roth IRA that has only $7250 in it instead of $10,000. That is why you should always pay taxes for a Roth conversion out of your pocket. If you can't pay the conversion taxes out of pocket, then don't convert to a Roth. Just rollover into a traditional IRA and you will keep all $10,000 and pay no taxes.
posted by JackFlash at 1:54 PM on December 10, 2010
For example, assume you have $10,000 in your 401(k) and are in the 25% tax bracket. If you rollover the $10,000 to a traditional IRA, you will owe no taxes.
If you rollover into a Roth IRA, then you will owe 25% or $2500 in additional taxes when you file your tax return next April. If you withhold $2500 from your 401(k) in order to pay taxes, it is just the same as if you withdrew $2500 to spend on a car. That is a non-qualified withdrawal and you will owe a 10% penalty on that withdrawal or another $250. So now you have increased your taxes in April by $2750 instead of the $2500 if you paid your taxes out of hand. Further, you now have a Roth IRA that has only $7250 in it instead of $10,000. That is why you should always pay taxes for a Roth conversion out of your pocket. If you can't pay the conversion taxes out of pocket, then don't convert to a Roth. Just rollover into a traditional IRA and you will keep all $10,000 and pay no taxes.
posted by JackFlash at 1:54 PM on December 10, 2010
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The last thing you want to do is pay taxes or penalties. Leaving it there is a way better option than paying taxes or penalties.
posted by oreofuchi at 12:46 PM on December 10, 2010