Today TaxMama® hears from Nic in the TaxQuips Forum, with this common misconception. “Nic is disabled and withdrew his money from his retirement plan. Now he’s trying to figure out how to avoid paying taxes on this money.”
Dear Nic and Family,
Mike Reed, EA and I tried to explain this to Nic very explicitly. Yet, he persisted in believing that his withdrawal should not be taxed. He is not alone in that belief. So, let me clarify this before you draw out your retirement, too.
Yes, it is true that there is special tax treatment provided to those who must retire early due to a permanent disability. (Note: I said PERMANENT, not just something that will keep you helpless for a few months or a year.) (Also, there are certain other ways to avoid the penalty, as well.)
The special treatment is limited to a waiver of the IRS 10% early withdrawal penalties, for folks who are under age 59 ½ when they draw the money. (The same waiver applies to your state penalties.)
But be clear on this, the money you draw out is totally subject to income tax. So expect to pay taxes on these funds. In fact, if you withdraw all the money at once, expect this to put you into the highest tax bracket you have ever been in.
How can you avoid these high taxes?
1) If you have made contributions to your retirement account after paying taxes on the money – track those amounts. Those funds will not be taxed when you withdraw them.
2) If you must close out your retirement account, have those funds transferred directly to a new IRA you create just for this purpose. Then withdraw the money as you need it.
3) Do not withdraw money you do not need to cover current year living expenses. The smaller the draw, the lower your tax bracket – and the lower the taxes.
4) Make sure when you take your draw, that they withhold enough money to cover all your taxes – for the IRS and state. Often, that 20% they withdraw only for the IRS is not enough to cover the taxes you will owe.
5) And yes, even the withholding is counted as part of your taxable income. So do some planning and run the numbers to see if withdrawing all that money is worth it. Perhaps there is a better way to cover your expenses?
6) One last thing that is not in the recording – When you draw the money directly from the retirement account, there is NO waiver of the penalties. That waiver is only available if you first move the money to an IRA and THEN take the draws.
And remember, you can find answers to all kinds of questions about early withdrawals and other tax and business issues, free. Where? Where else? At www.TaxMama.com.
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