Sunday, March 6, 2011

But I Paid the Tax!

Q: I just had my taxes done and I owe a lot of money. My CPA says it is because an early IRA distribution I took. I don’t understand because I paid the tax when I got the money. What is he talking about?

A: Well, this is a common misconception. I think the confusion is that you had tax withheld. But you did not actually pay the total tax due.

Just like the taxes withheld from your normal paycheck, you made payments towards your year-end tax bill. But you did not actually pay the total tax due. The total tax on April 15th may be more or less than what was withheld from your check.

If you paid in less via these withholdings than the total tax, you are going to owe at April 15th. If you paid in more than the total tax, you get a refund.

Obviously this is too late for you and your transaction, but taking funds out of your 401(k)/IRA is one of the last places you should go to get cash. That is especially true if you are younger than 59½ because then you will likely have the 10% federal penalty. You also have the ordinary federal income tax and your state income tax.

In North Carolina, where I live, those taxes and penalty can easily eat up more than 40% of the distribution. If you only had 15-20% withheld, you still have 20-25% due.

So next time, talk to your CPA before you take a distribution like this. Maybe your CPA can help you find better financing options. If not, you will at least know how much tax this is going to cost you.

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