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Farrell: Tapping 401(k) is unwise because of tax bite

  • Article by: CHRIS FARRELL
  • May 17, 2014 - 4:52 PM

Q: I recently took a new job with another company and now have a 401(k) at the old employer worth about $42,000. Normally I would just roll it over to my new employer’s plan. However, my husband is disabled and we would like to add a deck and handicap-accessible entrance to our home as well as some landscaping. We have some savings and can afford to get a bank loan to help with the cost of this project but need the $42,000 to cover the remainder of the costs. We have a mortgage and car payment, no credit card debt and we save about $1,250 each month.

My question is: if we converted the 401(k) to an IRA, would we have access to the full amount as liquid cash and be penalized less than if we simply cashed out the 401(k) and took the hit on taxes? My husband and I are both in our mid-40s so we know we would have an early-withdrawal penalty either way.

Maryann

 

A: I understand the lure of tapping your retirement savings for the deck, handicap accessible entrance and landscaping. My own sense was that using your 401(k) money is not the way to go, but to check my reaction I consulted with two certified financial planners and both strongly suggested that you leave the retirement money alone.

Whether you liquidate the account and take the distribution as cash from your former employer’s 401(k) or put the money into a rollover IRA and then withdraw the money, the consequences remain the same: The distribution is considered taxable income.

In addition, as you note, taxable distributions from a 401(k) and similar qualified retirement plans and IRA are subject to the 10 percent early withdrawal penalty (withdrawals made before age 59 ½). So, after taking into account federal and state taxes and the penalty, you could end up reaping as little as half the $42,000. “This is a terrible place to get money to add a deck and landscaping,” says Joel Greenwald, certified financial planner (and doctor) at Greenwald Wealth Management in St. Louis Park.

To be sure, there is a potential exception to the 10 percent penalty that might apply to your circumstances. Looking only at the portion of expenses tied to improving access to the home for your disabled spouse, if medical expenses exceed 10 percent of your adjusted gross income (AGI) — a big “if” — that portion of the distribution might not be subject to the 10 percent penalty, notes Bradley Weber, director of investment advisory and principal for Aspiriant in Minneapolis. In addition, medical expenses that exceed 10 percent of AGI would also be deductible and could help offset some taxable income. (Disclaimer: Seek professional tax guidance before acting on taxes, medical expenses and retirement plan distributions. These comments are only suggestive. The devil is always in the details with taxes.)

That said, Bradley agrees with Greenwald: Liquidating your 401(k) isn’t the way to go.

“Long-term, she would be better off to allow her retirement savings to grow tax-deferred in a 401(k) or IRA and avoid early withdrawals,” says Weber.

Both Bradley and Greenwald recommend rolling the retirement money into your new employer’s plan (if allowed) or into a rollover IRA. You could take advantage of today’s low interest rates to complete the project (perhaps scaling it back). You could then put the $1,250 your putting into savings to pay off the loan within a reasonable time frame.

 

Chris Farrell is economics editor for “Marketplace Money.” His e-mail is cfarrell@mpr.org.

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