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"?

DIG

Short term view above. Top red line is resistance at 62.00 Bottom red line is support at 26 and some change. Bought at 34.25 this morning and closed at 36.83

Below is the longer term view. Red lines are at the same levels on both charts.


Dig goes up 200% of the Dow Jones US Gas & Oil Index. It is near support and has a long way to go before it hits resistance. Bought this morning at $34.25. Support is at about $27 and the first round of resistance isn't until $62. This means there is about 3.5 to 1 ratio of return to risk which makes it acceptable.

Your 401k, Recession's Perfect Sacrifice

Think that if you put your head in the sand and wish this recession away, that your 401k will be OK? It might be more like 0K (that’s ZERO K for those of you in Rio Linda).

The last recession came like a thief in the night. Those napping awoke and found they lost a majority of it. Many began calling it their 41k.

Don’t think that the Wall Street types are going to take pity on you just because you don’t care about what’s going on. These guys are great at telling you to buy and hold while they are moving their money around trying to catch the latest greatest deal. It’s ironic that you’re limited to moving the funds around in your 401k because the fund’s managers were caught moving theirs around EVERY day. Most of the people I talk to don’t even know HOW to move the funds around in their 401k!

I know it’s hard to know exactly what to do. It’s not a perfect world. We don’t even know if we’re actually IN a recession or not. In fact the government types that officially determine when recessions start and end can’t agree. In the last four recessions, it took them on average 8 months to let us know it started. Many recessions don’t even LAST 8 months! They are even worse letting us know when they’re done. On average, it took them almost 2 years to let us know the recession was over. If THEY don’t know, how are WE supposed to?

Think that the company running your 401k cares about you? When was the last time someone from there called you and said you should re-think the way your 401k is invested? When was the last time ANY financial type called you and said ANYTHING about your 401k? Maybe they’re too busy paying attention to their own. It’s probably the largest single investment you own. It’s also probably the single most ignored thing you own. I saw people who went into the last recession with $100,000 and came out with $30,000. I wonder how long it took them to earn the $70,000 they just gave away; a heck of a price to pay for not caring.

Don’t let them put your hard earned, perfect 401k onto the alter of Recession. Instead, sacrifice a little of your time and pay attention to your 401k, it will keep it from becoming THE Suckers Perfect Sacrifice.

Recession History

Since history seems to repeat itself, maybe we could learn something about the current possible recession by studying this country’s recession history. Since pictures are supposed to be worth a thousand words, we will look at the recession history in charts.

I work with investments, so I’m particularly concerned with recessions due to the fact they can have a very negative impact on investment account values. I’m going to look at the recession history with particular focus on how each recession affected the Dow Industrials Stock Index. I have Dow Index data back to 1930, so we will start there.

I have known for some time that the market has seems to operate in approximately 15 year cycles. The market goes up for 15 years, then seems to go sideways for the next 15 years. This growth and then consolidation pattern happens frequently through out history as we will soon see.

This first chart (figure 1), shows the Dow Industrials index from 1930 through 1945.

Figure 1

The light blue areas are times of recession. The first one, however, was the great depression. We all know the effect the depression had on stock values. The Dow lost over 88% of its value between 1929 and 1933. Notice the nice rebound it made following the depression. It increased 345% over the next 4 years. We will see there is a theme in the recession / expansion cycle. Recessions are relatively short and can be very violent to investors in the stock market. The expansion period following recessions are much longer and historically quite good.

One thing you need to be extremely aware of though. Numbers and percentages can be deceiving. I just mentioned that the index lost 88 percent, but then gained 345%. Sounds like you made up all your losses and then some. Not quite.

The dirty little secret to investment losses is this: if you lose 50% of your portfolio, you need to make 100% just to break even. This is an ugly little fact, but lets look at it in real life. If you had $100,000 and lost 50%, you would be left with only $50,000. How much do you have to earn on your $50,000 to get back to even? You need to earn another $50,000. This is 100% of what you currently have. You lost 50% and must gain 100% just to break even.

Let’s look at our chart and see how this works. In 1929 the Dow had a high of around 380 and in 1933 a low of about 48. This is an 88% decrease in value. Over the next 4 years it went from 48 to 187. This is a 345% increase. Sounds like you made up the 88% loss and then some. Unfortunately you have only gained back just over half of what you lost. This also is a recurring theme. When a recession takes huge bites out of portfolio values, it normally takes many years just to break even again. Not to get ahead of myself, but the Nasdaq has only regained about half of what it lost during the last recession. And This is 7 years later! The Dow and S&P 500 took about 6 years to finally break even. The kind of time periods required to recover definitely make the study of the recession history worth while.

Figure 2

Now that some of the back ground work is complete lets look at the next 15 years, from 1945 through 1960 (Figure 2). We will see that it was about in 1955 that the Dow finally got back to where it was before the great depression. This was a very long 25 year wait. Imagine the poor retirees that retired before the depression and never again regained their original portfolio value!

Remember the last 15 years were mostly down then sideways (1930 through 1945). This next 15 year time period had very mild recessions with the worst only causing a 15% drop in the Dow. Overall, the Dow gained 267% over this 15 years. A very good reward for a minimum amount of risk. This leads us to the next 15 years, 1960 to 1975 (Figure 3).

Figure 3

The 15 year cycle is definitely in effect. The last 15 years were very tame yet had a nice return. This 15 years was not for the feint of heart. Gain was very little over the period, but volatility was killer. The period started out with a wonderful 75% gain, but gave it all back by the end. As you can see, the recessionary periods were very violent. The reward available in this market was much smaller than the risk.

Thus far, we had a 15 year period that was horrible, one that was very nice, then another horrible one. Without looking ahead, we might guess that the next 15 year time period would be another nice one. Let’s see.

Figure 4

Yep, looks just beautiful. Began with a 6 year period of consolidation (going sideways), but when it was done consolidating, it moved up very nicely. It moved from around 800 in ’82 to 2800 by 1990. This represents a 250% increase for the period. The volatility for the period was pretty tame. At least if you look at the volatility caused by recession. The largest pullback in value was the ’81 to ’82 recession which was about 18%. The big pullback in August of ’87 was about 30%, but wasn’t caused by recession and didn’t take that long to be regained; all in all a very fruitful 15 years.

This would lead me to believe that the next 15 years would be tumultuous again as the market needs to digest its gains. Let’s take a peek at Figure 5.

Figure 5

The roll the market had going continued for the first half of this period. It gained 300% in just 8 years. This was more in the first half than the others gained in their entire 15 year period. This didn’t go un-noticed however, and the market promptly took back a healthy 35% through the recessionary period. It took until mid way through 2006 to finally get back to even from the highs seen in ’99. Once this was achieved, however, the Dow just kept going. It extended it’s gains through the expansion period, hitting new highs.

Which brings us to today. There is much talk about the beginning of another recession. We’re at the end of a period that should have shown consolidation, but instead had another large run up. This run up wasn’t without sizeable volatility. Notice we’ve just broken the support line drawn. I’ve drawn support lines throughout the charts. Had you sold upon breaking the support lines over the years, you would have saved yourself many heart aches and wouldn’t have had to wait as long to break even again.

In summary, I would say that the recession history points to our next recession causing havoc on the Dow. When will the next recession be or are we already in it? I’ve covered this dilemma in another article. I think we are already in it. I believe the Dow just broke support and has a lot of potential to continue down
If you’re concerned about your 401k in this market environment, visit 401k plan facts. Help is available.