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).
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 firstname.lastname@example.org or www.pivotpointadvisors.net