How much will the tax be on cashing out a 401k?

Due to massive downsizing during this economic downturn people are wondering How much will the tax be on cashing out a 401k. Let's go through the process of calculating an example.

Our example is a married couple who are earning One hundred thousand dollars per year. One of them just got downsized and now they only expect to make $75000 per year.

Remember when you cash out a 401k prior to age 59 1/2 you will not only pay Federal and State income tax but also a Federal and State penalty. The total of the 4 items will determine your total taxes due upon early termination of your 401k plan.

First we need to calculate where this couple is in their tax bracket. We will need to determine how much their exemptions and deductions are. Each personal exemption is worth $3650.00. Since this couple has no kids their first ($3650.00 X 2) $7300.00 of income has no tax.
We next will assume they get no more than the standard deduction which should be $11400.00 in 2009. If we add the exemptions and deductions up we get $11400.00 + $3650 = $15050.00. This means the first $15050.00 of income has no Federal income tax attached to it.

From here we start paying taxes in incremental tax brackets:

• The next $16700 is going to be taxed at 10% (once we use all this we will still have $43250 left).
• Then the next $51200 will be taxed at 15%. (Since we only have $43250 left we won't fill up this tax bracket. We will still have $7950 left over).

Now we know that we are in the 15% tax bracket prior to cashing out our 401k. Let's say their 401k has $100000 in it. If it is all pulled out we will continue to fill up more expensive tax brackets. Remember we only have $7950 left over in our 15% bracket. Once that is used up we almost double our tax rate:

• Next $69150 is taxed at 25%. (we still have $22900 left for the next bracket).
• Next $71800 is taxed at 28%. (thank goodness we only use $22900 of this bracket).

To summarize:

Federal taxes due from regular income:

• $16700 x 10% = $1670
• $51200 x 15% = $7680

Sub Total $9350 Federal Taxes due to income.

Now lets add our 401k cashout:

• $7950 x 15% = $1192
• $69150 x 25% = $17287
• $22900 x 28% = $6412

Sub Total $24891 Federal Taxes due to 401k cashout.

Now lets add in State income tax. Each state is different. In Wisconsin we pay around 7% and the exemptions and deductions are very different. So I will make a ballpark guess of $4200 taxes due to income and another $7000 due to the 401k cashout.

Now we must finally add the Federal and State tax penalty to our total. The Federal is at a 10% rate and the State (at least in Wisconsin is 1/3 of the Federal. we will call it 3%). This makes a Federal penalty of 10000 and a state penalty of $3000.

Let's add it all up:

Federal income tax due on cashout: $24891

State income tax due on cashout: $7000

Federal penalty: $10000

State penalty: $3000

Total Taxes due to 401k cashout: $44891.00

You can see in this case that our normal couple would lose about 45% of their 401k due to taxes and penalties!!!

It is very wise when considering a cashout that you only cashout what you need. The rest can be rolled over to an IRA where no tax will be due. You can still keep the investment in the IRA liquid in the event you want to take another distribution next year when you might be in a more favorable position within your tax bracket.

How much will the tax be on cashing out a 401k? PLENTY!! Be wise and try to do a little over a few years in order to keep your amount owed to a minimum. Feel free to contact me if you have any questions. I'm happy to help. www.ewatch401k.com or john.norquay@gmail.com or www.pivotpointadvisors.net

Can I roll my 401k to a Roth IRA?

Since this downturn in the market many have been asking "Can I roll my 401k to a Roth IRA"? The simple answer is Yes. You must first ask yourself what the consequences are. The following are the basic questions you should be asking yourself before deciding to roll your 401k to a Roth IRA.

What is the difference between a 401k and a Roth IRA?
There are effectively 4 different places in life that trigger income tax. First When you EARN money Second when the money you've invested GROWS each year this growth can be taxed. third when you decide to SPEND the money and fourth at DEATH whatever is left for your heirs can be taxed. I mention these different times of taxation because the only difference between the 401k and the Roth IRA is WHEN you pay the tax.

Taxation of the 401k:

• When you EARN the money and put it into the 401k it is NOT taxed.
• When the money grows each year the GROWTH is NOT taxed.
• When you decide to begin spending the money (usually retirement) it IS taxed.
• Whatever is left over upon your death the balance goes to your heirs and IS taxed.

To summarize taxation of the 401k: You put a small amount away each year. This amount is tax deferred. You do this for many years and the money is all growing without taxation. Once you hit your retirement years it has turned into a LARGE amount of money (hopefully). This LARGE amount of money will all be taxed by either you or your heirs.

Taxation of a Roth IRA:

• When you put an amount away each year you first PAY the tax.
• When it grows each year the GROWTH is tax free.
• When you decide to spend it in retirement it is tax free.
• Whatever is left over for your heirs is tax free.

You effectively pay tax on the small amount of money that goes in and the big amount later is completely tax free! Personally I believe the Roth IRA is too good to be true. I believe when they decide to increase taxes this will be one of the first things to go. Hopefully they will grandfather all the money that is already in the account if and when they change the rules.

So should I or shouldn't I transfer all or some now?
First you should realize that you must pay the taxes due on any amounts that you rollover. They don't actually call this transfer a rollover. It is officially called a Recharacterization. Many are wondering if it makes sense to change to a Roth now since their account values have depreciated so much. The upside is if you switch and the account returns to the values it once had then you only paid tax on todays amount which in many cases is only half.
The downside is you need to have enough money at tax time to pay the taxes due. Usually it is best to have this tax money on the outside of your plan. Try not to use the money from your plan to pay the tax. It is a very expensive way to pay the tax.

How much tax will I owe?
Since I'm not a tax advisor I would have to refer you to one. What I can tell you is how the tax brackets work. You need to figure out what percentage rate you will be assessed on the rollover. Here's how taxes work:

• The first taxable income isn't taxed because you have personal exemptions to offset it.
• The next amount of taxable income isn't taxed because you have deductions to offset it.
• If you have more taxable income than allowed for exemptions and deductions you begin paying in the 1o% bracket. Each dollar here is assessed a tax of 10%.
• Still more taxable income? After the 10% bracket is the 15%.
• Next is the 25%
• . . .and up.

Hopefully you get the idea. Look to see which tax bracket you have gotten into without any rollovers. Check to see how much room you have left in that tax bracket. I usually try not to have people go above their current tax brackets. I prefer to have some transferred this year and maybe more next year. Slowly get it over through the course of a few years so that you are keeping taxes as low as possible.

I've developed a spreadsheet to help people with this planning. It is free of charge you just need to contact me if you would like a copy. I've also developed a website that helps you keep your 401k invested according to the market conditions at http://www.ewatch401k.com/ .

Once you go through this entire process yourself you will be the expert when someone approaches you and asks "Can I roll my 401k to a Roth IRA"?