Know the Difference Between Rules for IRAs and 401(k) Plans

Many investors have both IRAs and 401(k) plans from their employer. It’s easy to confuse the two types of account because similar options and conditions pertain to both. However, IRAs and 401(k)s have their differences, and it can be costly when investors make the mistake of believing an option is available when it isn’t.

An example is the 10% penalty for withdrawals prior to age 59 1/2. Individuals who participate in 401(k) plans with their employer have an option at age 55 not available to IRA participants: Once they are 55, if they retire or get laid off or fired, they can select one of three withdrawal options that avoid the 10% penalty on their distributions. However, these options are quite restrictive and not very flexible.

Another option available to some 401(k) participants is a plan loan. The loan can be repaid without penalty while the individual remains employed and participating in the plan. However, if the employee leaves without repaying the loan in full, any amount outstanding is considered a distribution, is taxable and carries a 10% penalty prior to age 59 1/2. (IRA participants do not have a loan option.)

IRAs have some options not available with 401(k)s. Specifically, IRA holders are allowed to make early withdrawals without incurring a 10% penalty for the following: higher education, the purchase of a first home and health insurance payments (in the case of unemployment). Withdrawals are taxable at ordinary income tax rates. Unfortunately, some 401(k) participants make withdrawals for these purposes not knowing that they will be incurring a 10% penalty if made prior to 59 1/2.

Some 401(k) plans allow partial rollovers to IRA accounts, even while the account holder is still employed and participating in a 401(k) plan. By rolling over some of the 401(k) funds into an IRA, the individual then has the option to make withdrawals for higher education, a first-time home purchase or health insurance without incurring a 10% early-withdrawal penalty. However, withdrawals are taxable at ordinary income tax rates.

Some investors may find themselves in a situation in which they have no reportable income in a specific year. In this situation, they are tempted to make withdrawals from their retirement plan. They may believe that because they have no income to report, they do not incur a 10% early withdrawal penalty. That is an incorrect assumption. Even if they have no net reportable income for the year, the IRS has ruled that the 10% penalty is still applicable for all distributions from retirement plans for those younger than 59 1/2.

Another potential pitfall is associated with medical expenses. The IRS allows an exception to the 10% early withdrawal penalty on both IRAs and 401(k)s when the funds are used to pay medical bills in the same year the distribution is made. So, it is important to make the withdrawals and payments in a timely basis (same year). Otherwise the IRS will disallow the exception, and a 10% penalty will apply.

Moreover, the 10% exception only applies when the funds cover unreimbursed medical expenses that exceed 10% of adjusted gross income (AGI). When an individual withdraws funds from his/her retirement plan, his or her AGI increases, and the 10% floor increases as well. For example, a $10,000 withdrawal increases AGI by $10,000, and the floor increases by $1,000. So, a taxpayer with an adjusted income of $50,000 prior to the withdrawal would only be able to claim a deduction if he/she had medical expenses that exceeds $6,000 (10% of $60,000). A taxpayer who does not itemize will be able to use the exception.

The bottom line is that individuals who make withdrawals from their retirement accounts need to understand the regulations to be sure they will not incur penalties. If you are not sure of the regulations, discuss the situation with your financial adviser or tax preparer.


(Article written by Elliot Raphaelson)