Income Tax Relief When Withdrawing from your IRA

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income tax relief

Life may serve up some hard times, especially the need for cash when we don’t have it. If you’re working, though, you might consider taking money from a 401k or IRA to meet immediate needs.  The intent of these funds was of course to supply a source of cash to support retirement and for income tax relief during the contribution years.  Taking money from your tax-deferred savings is very costly for you – even if you are about to retire.

Tax-deferred financial savings consist of IRAs, 401(k)s, and other qualified plans. They are designed for retirement, and, therefore, have penalties along with taxes for cashing them in early, prior to the intended time. Because they are tax deferred and enjoy tremendous income tax relief while they grow, what you withdraw from these accounts are taxed at ordinary (the highest) income tax rates. If you are less than 59½ years old, you’ll pay a 10% distribution penalty on top of the income tax on any withdrawals you make (there are exceptions including the 60 day rule).

Although you will pay income tax on these withdrawals when you retire, taking an early withdrawal while you’re still working generates more loss than you might believe – just the exact opposite of the income tax relief you seek. You’re pressured to pay a higher tax bracket rate on your distribution and you lose the future tax-deferred growth you’d get on that money.

Expensive Instance
Let’s imagine you need $20,000. How much do you have to withdraw to pay for the tax (and early distribution penalty if applicable) if you’re employment income is $92,000 and you are single?

Now if you need $20,000 after taxes, you need to take out more to cover the tax on the distribution. And here’s the kicker. It’s not 28% more, but 38.9% more even if you’re over age 59½. That’s $27,778! Why?…simply because if you pull out $27,778, you lose  $7,778 to tax leaving you with your ‘needed’ $20,000. From a standpoint of income tax relief, it could be even worse because the money you pull out, could push you into a high tax bracket and the distribution might push you from the 28% bracket to say 33%.

The table below shows how much more you pay if you are still under 59½. You may notice getting cash from an IRA or qualified plan may be very costly.

Tax Loss for Withdrawing a Tax-Deferred Account
Amount needed 28% bracket 28% and under 59 1/2 (w/10%penalty)
$20,000 $27,778 $32,258
Excess withdrawal as percent of $20,000 38.9% 61.1%

 

If you require money, borrow it – from your home equity, a friend, a 401k loan or as a regular bank loan. It’s less expensive this way; and you may repay it afterwards – once you retire and your income tax bracket is hopefully reduced. Obtaining cash through credit is excellent as it places money in your hands without any obligations to IRS-the ultimate income tax relief.

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