Take Cash Pay Tax

Take the Distribution & Pay the Tax

Taking the money is tempting for many people – especially those who need extra income until they can find a new job. But you should resist the temptation.

If you truly need the income to help meet expenses, or for a child’s education or to purchase your first home, there are alternatives to pursue. We’ll discuss them later.

Taking your distribution in cash can lead to substantial erosion of the assets you’ve worked so hard to accumulate. The purpose of a retirement plan is to INVEST for retirement. The IRS assesses penalties to discourage you from spending your retirement plan assets early.

To further illustrate what happens when you take the distribution and pay the tax (and penalties, if applicable), let’s look at a hypothetical cash distribution scenario.

Distribution in cash cost you $18,500, or 37%, of your hard-earned money..

For example, assuming you have a distribution of $50,000. When your company issues a check to you directly for all or part of your qualified retirement plan assets, the company is required by law to withhold 20% for federal taxes.

In our example, that means the check you receive is in the amount of $40,000 (20% of the original amount $50,000 is $10,000.)

You’ll have to wait until your federal tax return is completed next year to claim that $10,000 your employer withheld. That is, provided you don’t have to use the withheld money to pay any other taxes that you owe.

Also, be aware that the $10,000 withheld is considered income by the IRS, even though you don’t actually receive it.

To compound the matter, the withheld money could potentially push you into a higher tax bracket.

But there’s more. For purposes of this example, you’re in the 27% federal tax bracket. So, 27% of your $50,000 distribution is $13,500. Since $10,000 was already withheld, you owe another $3,500 come the annual April 15 deadline.

Finally, if you’re either under the age of 55 and retired or under the age of 59 ½ and not retired, any distribution from a qualified retirement plan is subject to both income tax and a 10% federal penalty tax. There is a special tax provision under which assets are not subject to this penalty tax, but we’ll address this later. So, in our example, you’ll hypothetically be young enough to have the February 2005 10% federal penalty tax apply to your distribution, which means you’re liable for another $5,000 by April 15.

In the end, the hypothetical decision to take the

distribution in cash cost you $18,500, or 37%, of your hard-earned money.

Even if your tax situation enables you to retrieve as a refund the 20% of your distribution that was withheld, you still owe the 10% federal penalty tax (in this example, that’s $5,000). So, for those of you who are thinking about using your qualified retirement plan distribution to buy a new car or go on vacation, think again.