Avoiding the Early Withdrawal Penalty of 10%
The most common penalty is a 10% early withdrawal tax on funds withdrawn from your retirement account before age 59 and a half. This penalty is added to the standard federal income tax due on the withdrawal, plus state income tax if you live in a state that imposes an income tax. However, there are some exceptions.
You may be able to withdraw funds early without paying the penalty for various reasons:
- You are disabled.
- You are paying taxes owed to the Internal Revenue Service (IRS).
- You have unreimbursed medical expenses that are at least 7.5% of your adjusted gross income.
- You are a reservist called to active duty.
- You choose to take substantially equal periodic payments.
- You leave your employer during or after the year you turn age 55, or age 50 if you are a public safety employee for a state, county, or municipality, and participate in a government-defined benefit plan.
Your beneficiary may also be able to withdraw the funds without penalty if you die before age 59 and a half.
Be sure to have proper documentation to prove that you meet any exceptions.
Avoiding Double Taxation on Excess Contributions to 401(k)
The Internal Revenue Service (IRS) sets contribution limits on 401(k) plans, which dictate the maximum amount you can put into your account each year. The limit is $20,500 in 2022, up from $19,500 in 2021, with an additional $6,500 catch-up contribution if you are age 50 or older.
If you contributed more than these amounts to your 401(k) in a given year, you have made what is called an “excess contribution.” You must report this amount as taxable income during the current tax year, and you will need to pay federal income tax on the funds when they are withdrawn after retirement. Therefore, double taxation is imposed on contributions that exceed the annual limit.
However, you can avoid income tax in the current year if you are able to remove the excess amount from your retirement account, plus any earnings on the excess contribution, before the tax filing deadline for the tax year in question. The removal of the excess amount is called a “corrective distribution.”
Avoiding the 50% Tax on Failing to Withdraw Required Minimum Distributions (RMDs)
Under the law, you must begin withdrawing funds from your 401(k) account each year once you reach a certain age after retirement. The first required minimum distribution (RMD) must be taken by April 1 of the year following the year you turn age 72, or age 70 and a half if you reached that age before January 1, 2020.
You must then continue to withdraw RMDs by December 31 of each year, starting from the year you begin. You must have taken your first RMD by April 1, 2021, and an additional RMD by December 31, 2021, and again by December 31, 2022, if you turned age 70 and a half on July 15, 2020.
Note: Required minimum distributions (RMDs) are required for almost all types of retirement accounts, including 403(b) and 457(b) plans, IRAs, and Roth 401(k)s. However, RMDs are not required for Roth IRAs during the owner’s lifetime.
The amount you are required to withdraw is calculated by dividing your account balance as of December 31 of the previous year by a factor based on your life expectancy. Appendix B of IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), provides tables for the life expectancy factors that apply to 401(k)s. Your retirement plan administrator may also be able to inform you of your required minimum distribution (RMD).
Important:
You must take the required minimum distributions (RMDs) from each if you have more than one 401(k) account. You can take the total required minimum distribution (RMD) for all IRAs from one account, or you can take it in pieces from multiple accounts if you have more than one account.
You must file Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, along with your tax return Form 1040 if you failed to take the required minimum distribution (RMD) and you must pay a 50% penalty on the amount you should have withdrawn.
The Internal Revenue Service (IRS) may waive the penalty if you fail to take the required minimum distribution (RMD) due to a reasonable error and you are trying to correct it. You should attach an explanatory letter with the manner you prefer to your Form 5329.
UBTI Requirements
You may choose to invest in a structured business as a limited partnership or a master limited partnership if you are a high-net-worth investor with a self-directed 401(k) plan. You must file Form 990-T, Exempt Organization Business Income Tax Return, with the Internal Revenue Service (IRS) if these investments generate unrelated business taxable income (UBTI) of $1,000 or more.
You must pay estimated tax on income if you anticipate that your organization will owe more than $500 in taxes in a given year. The highest tax rate on unrelated business taxable income (UBTI) was 37% on income over $13,050 in 2021.
Reducing Fees on Mutual Funds
Most 401(k) money is invested in mutual funds, with some plans also offering options for exchange-traded funds (ETFs). Paying high administrative fees can significantly impact your investments over decades of investing.
The fee ratio for ETFs should be much lower since these funds often seek to passively match the return of a particular index. Management expenses should be kept as low as possible. The average fee ratio for an index equity ETF was 0.18% in 2020, and for an index bond ETF, it was 0.13%.
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Source: https://www.thebalancemoney.com/401k-penalties-to-avoid-357107
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