taxes

Roll over 401(k) loan or pay penalty, taxes?

George SaenzDear Tax Talk,
I am 46 years old. I had taken out a 401(k) loan with a current balance of $19,000. The company I work for was sold, and now I have to make a decision either to take the early withdrawal or to roll over the loan into my new employer's 401(k).

Due to the many tax deductions that I filed, I do not have a federal or state tax liability at the end of every year.

Should I roll over the loan to my new employer's 401(k)? Or should I just take the early withdrawal with the 10 percent penalty? As I mentioned, I do not have a federal or state tax liability when I file my returns. What would be my tax liability then?

Thank you.
-- Oscar

Dear Oscar,
Very critical thinking on your part: You're obviously very tax savvy. Normally, you can't roll over a 401(k) loan, but because your company was acquired and you weren't terminated, this is an option for you. If your tax situation is how you describe, then it wouldn't make sense to roll over the loan into your new employer's plan. Of course, you will owe the 10 percent penalty on the deemed distribution of the loan. I can't tell you exactly how much you will owe on the $19,000 because that depends on numerous individual factors. But as savvy as you were to pick up on the opportunity to not roll over, I can assume you can figure that out easily.

Since tax rates start out at 10 percent, you can probably get by paying less than 20 percent combined penalty and tax, which may be better than having to earn money in another year at a higher tax rate to repay the loan.

A lot of folks miss the opportunity to distribute from their retirement accounts when they would owe no additional taxes. For example, individuals older than the penalty age of 59 ½ may not consider withdrawing from their retirement accounts until they exhaust other savings. This would be a mistake if they could withdraw funds with little or no tax cost.

The other big mistake people make is taking all retirement funds in one year: a lump sum. Many years ago, some individuals could average lump-sum distributions over 10 or five tax years, essentially meaning the distributions were spread out and taxed at a lower rate than the individual's ordinary tax rate. However, the five-year averaging option was repealed in 2000, and the 10-year forward averaging remains only for individuals born before 1936. If you take all your retirement funds in one year, you'll probably overpay your taxes.

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