What are strategies that can lower the tax bite when removing money from a 401K? Compare the tax costs of borrowing from your 401k loan, or taking out a home equity loan. If your 401k is earning more than the after tax cost of a home equity loan (second mortgage) then it would make more sense to borrow from the home equity line.
The subject of taxes is complicated enough it seems, and even more so when it comes to investments. Paul Dlouhy, who advises investors on tax strategies, states that "There are usually too many variables to consider giving blanket advice on tax strategies and you should consult a financial advisor about your specific needs and situation"
One obvious solution is not to remove the money from a 401k - instead of taking money out, roll it over into another account, or obtain the money from elsewhere. Dlouhy also offers the following advice if you need to borrow a large sum of money: "Compare the tax costs of borrowing from your 401k loan, or taking out a home equity loan." If your 401k is earning more than the after tax cost of a home equity loan (second mortgage) then it would make more sense to borrow from the home equity line.
Furthermore, if you do borrow money from your 401k, you lose out on any employer matching contributions while you are paying off the amount of your loan. And if you lose your job or move employers, you generally have to pay back the loan in a short time.
"Unfortunately, you are going to have to pay taxes on any money you withdraw from your 401k plan, as well as a fee for early withdrawal" warns Dlouhy. The fee is usually around 10% of the total withdrawal amount. You will also end up having a higher taxable income for that particular tax year. You will also be prevented from making further contributions to your 401k, thus increasing your taxable income while you have the loan out.
The IRS also allows what is known as a withdrawal for financial hardship reasons. These would include: buying a house, preventing eviction from your home, paying college tuition fees that are due soon, and for medical expenses that won't be reimbursed. The most common reason for this type of withdrawal is for buying a home, which must be designated as your primary residence, and not a second home or vacation home. With this type of loan, you still have to pay income taxes but you do avoid an early withdrawal fee. Your employer may require evidence of the financial hardship.
You can also qualify to avoid the early withdrawal penalty if you become totally disabled, or are ordered by a court to withdraw the money for child support or to an ex spouse in the case of a divorce settlement.
Explains Dlouhy, "A hardship withdrawal is not the same as a loan, in that you cannot actually repay it - it may be a better idea to take out a 401k loan instead" (See question 15)
One way to avoid paying taxes on money you withdraw from your 401k is to rollover the money into what is known as an IRA rollover account; this is considered a traditional IRA account, so you don't need to pay taxes. Make sure the money is transferred directly into the new account - don't have checks or certificates issued directly to yourself.
