We are receiving a lot of question regarding withdrawals from a 401(k) account. Unfortunately, most of the questions seeking our advice come after an action has already been taken. We can’t emphasize this enough – Tax planning must be proactive – ask before not after.
401(k) Early Withdrawals
First, a withdrawal from your 401(k) account is subject to income tax. The money was deposited pre-tax and grows on a tax deferred basis. Meaning you pay tax later, when you withdraw the money. The benefit is the growth on $100 pretax dollars, than $60 after tax dollars. (Please refer to the Einstein example on our website.) And generally 60 year olds are in a lower tax bracket than when they were working. Obviously this thinking is Pre-Obama. So pretax deposits will always be subject to tax on withdrawals regardless of your age.
The 10% Penalty
The issue is the 10% withdrawal penalties. Usually, any withdraw, before age 59 1/2, is subject to the 10% penalty unless you meet one of the hardship exceptions such as:
- Separation from employment after age 55
- Medical expenses that exceed 7.5% of adjusted gross income
- To prevent eviction or foreclosure
- To pay for college
- Court ordered divorce settlement
Taking a 401(k) Loan
You can avoid the penalty and tax by taking a loan from your 401(k) account. Most plans permit a loan of up to 50% of the vested amount in your plan. The drawback with the loan is the lost value of the 401(k) account and the fact you repay the loan with after tax dollars. Your loan payments include a repayment of “lost” interest back into your account.
401(k) Withdrawals to Start a Business
We have gotten many questions regarding a 401(k) withdrawal to start a business and its qualification as a hardship withdrawal. The IRS does not permit this transaction free from tax and penalty. Many articles discuss the fact that it is “worth the risk” or “investing in yourself.” If your business venture is successful and your sources of capital are limited, the 401(k) withdrawal income tax and penalty may be well worth it.
FYI – A strategy does exist that involves a complex transaction for someone starting a business and using a 401(k) rollover into a newly established 401(k) plan and having the plan “invest” in the new business to cover wages and operating expenses. This transaction is complex and will be scrutinized by the IRS so a knowledgeable ERISA attorney is a must. If drafted correctly, the strategy does work.
Call us for help or with questions!
The Business Wealth Preservation Group is a professional services firm dedicated to providing superior individualized and custom service to individuals and their businesses in the areas of asset protection, tax planning, exit strategies, and wealth building. Simply put – we want to educate you on all relevant opportunities to put more dollars into your pocket, your business and your future.
We focus on leading edge, sophisticated, and safe business strategies that will help business owners structure, operate and maintain their business to take advantage of business and tax laws rather than being encumbered by them. We partner with the business, the accountant, and the attorney to ensure the business owners are capturing all available benefits that align with their business and personal goals.
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