Retirement Account Mistakes That Could Cause Tax Problems

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Before you choose to take money out of your retirement account, take the time to consult a tax advisor. There are many tricky rules with retirement accounts, writes Forbes, which can easily trigger unexpected penalties. If you don’t consult an expert and accidentally make an account withdrawal mistake, tax time could bring some unpleasant surprises. Here’s a list of five retirement account mistakes to avoid.

1. Hardship Distributions

“Your 401(k) retirement plan at work might allow you to take what’s known as a hardship distribution, even though you still work for the company and aren’t retirement age because of an emergency need. Many people think it’s a penalty exception, but it’s not,” says Forbes. In order to take penalty-free withdrawals from your retirement account, you typically have to be at least 59 1/2 (there are penalty exceptions such as disability.) Here’s an exception — if you incurred and paid for significant medical bills in the same year you took the hardship distribution (to the extent that you have deductible medical expenses that exceed 10 percent of your adjusted gross income), distributions that cover those expenses won’t be subject to the 10 percent early withdrawal penalty.

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2. RMDs

If you wait until you’re 70 1/2 to start taking required minimum distributions from a traditional IRA or 401(k), it can push you into a higher tax bracket, Bankrate says. A loophole that allows retirees to defer taking RMDs entirely in the first year can also be tricky. People can actually choose to wait until sometime before April 1 of the following year. Make sure you plan ahead, though, and understand how it will impact your taxes. Otherwise, the higher tax bracket could come as a surprise when tax time rolls around.

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3. Loans

If for whatever reason you decide to take a loan from your 401(k) and then leave your place of employment, you will have to pay back the loan per the loan agreement. If you don’t, that outstanding balance is then treated as a taxable distribution, which is subject to the 10 percent penalty if you’re under 59 1/2, Forbes says. You can get stuck in this situation if you’re short on money when it’s time to pay back the loan, or you somehow don’t see the paperwork. If it’s not paid back, expect to see a 1099R at tax time.

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4. IRA Rollovers

“Moving assets from a 401(k) into a special IRA called an IRA rollover can also cause tax troubles if not done right. When you move the money from a 401(k) plan directly to the new account without ever touching a check, it’s called a trustee-to-trustee transfer,” Bankrate says. However, investors can also get the money directed to them. Here’s an important note: if the money is sent as a check in the account holder’s name, that person has 60 days to put the money into a rollover IRA. Remember: account holders are allowed one 60-day rollover per year.

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5. Age 55 Distributions

With this rule, there’s an early distribution exception that applies if you stop working at your place of employment (retire, quit, or take a different position) in the year that you turn 55 or older and take a distribution from your retirement account after that separation. The mistake comes into play if you interpret this in a backward way.

“Say you leave your employer at age 52, then turn 55 and think, ‘Oh, good! I can start taking money out of my 401(k) penalty-free.’ Wrong! You left the employer before you turned 55, so the 10 percent penalty applies,” Forbes says. If you want to take money out before you hit 55, you can do it penalty-free by taking substantial equal payments. That means you annuitize your 401(k) or IRA by taking out an amount that applies to your age. Another thing to keep in mind is you have to continue taking equal payments until five years after you start or you hit age 59 1/2, whichever comes later.

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