bad advice leads to big bill

[2bfrugal]

Due to medical issues, we were getting foreclosed on. We made medical bills instead of the mortgage and got behind. We took money out of a 401K and were told at the time that all taxes and fees were taken out. Now we find out they were not taken out, and we owe the IRS $40,000 in taxes.

I guess it is good the house is now paid for???

Is there anyway to reduce this since it was for forclosure? We literally paid 12 hours before they were auctioning off the house. I thought this was in one of the Obama promises?

We will be having to go into an attorney on this, but wanted insight from anyone who may have been through the process themselves.

[jpg7n16]

We took money out of a 401K and were told at the time that all taxes and fees were taken out. Now we find out they were not taken out, and we owe the IRS $40,000 in taxes.

Whoever told you that gave you bad information, or you simply misunderstood. Brokerage firms do not calculate your tax liability. It's not like sales tax at Wal-Mart. The percentage is based on a number of factors (income, filing status, distributions, deductions, credits, exemptions, etc.)

Factors your brokerage firm does not have access too.

Now there was very likely an amount withheld TOWARDS taxes. Say 20% or so. But that was not your whole tax liability. That was just an advance on your total tax bill that would inevitably be due.

How much did you take?

I guess it is good the house is now paid for???

Not really. Especially if you are under 59 1/2. Then it's pretty terrible. You cashed out your retirement, owe a ton of taxes, and should have only taken what you needed to get current on your home, not pay the whole thing off.

Is there anyway to reduce this since it was for forclosure? We literally paid 12 hours before they were auctioning off the house. I thought this was in one of the Obama promises?

Obama doesn't control the IRS. And the answer to your question is, probably not. Speak to a CPA about your situation, but it's very likely that you do not qualify for an exemption to the penalty.

And taxes are always due on income. 401k distributions are income. Obama didn't change that.

[2bfrugal]

It was the brokage people who told us that. We took out 225,000 and there is 800,000 remaining. We are 60. They took out enough for the early penelity and part of the taxes. We talked to the same rep twice and had detailed notes. He assured us over and over, that the law made "tax allowances" for forclosures...... Later we called and spoke to a supervisor and now we understand the orginal rep no longer works there.

[jpg7n16]

It was the brokage people who told us that. We took out 225,000 and there is 800,000 remaining. We are 60. They took out enough for the early penelity and part of the taxes. We talked to the same rep twice and had detailed notes. He assured us over and over, that the law made "tax allowances" for forclosures...... Later we called and spoke to a supervisor and now we understand the orginal rep no longer works there.

Again, then whoever you spoke to gave you wrong information, or you misunderstood.

The brokerage firm has no way of knowing what the tax implications will be. The IRS calculates tax liability, not a brokerage firm.

Now given that you are over 59 1/2, there is no 10% penalty regardless of the reason for withdrawal. Foreclosure does not exempt anyone from the 10% penalty, but being 59 1/2 does.

From: Tax Topics - Topic 558 Tax on Early Distributions from Retirement Plans, Other Than IRAs

To discourage the use of retirement funds for purposes other than normal retirement, the law imposes a 10% additional tax on certain early distributions of these funds. Early distributions are those you receive from a qualified retirement plan or deferred annuity contract before reaching age 59 1/2.

...

There are certain exceptions to this additional tax. The following six exceptions apply to distributions from any qualified retirement plan:

1. Distributions made to your beneficiary or estate on or after your death
2. Distributions made because you are totally and permanently disabled
3. Distributions made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary. If these distributions are from a qualified plan other than an IRA, you must separate from service with this employer before the payments begin for this exception to apply
4. Distributions that are equal to or less than your deductible medical expenses under section 213, that is, the amount of your medical expenses that is more than 7.5% of your adjusted gross income. You do not have to itemize to meet this exception. For more information on medical expenses, refer to Topic 502
5. Distributions made due to an IRS levy of the plan under section 6331
6. Distributions to qualified reservists. Generally, these are distributions made to individuals called to active duty after September 11, 2001 and on or after December 31, 2007.

The following additional exceptions apply only to distributions from a qualified retirement plan other than an IRA:

1. Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50
2. Distributions made to an alternate payee under a qualified domestic relations order, and
3. Distributions of dividends from employee stock ownership plans.

Here's what the IRS says about foreclosure:
Home Foreclosure and Debt Cancellation
Publication 4681 (2011), Canceled Debts, Foreclosures, Repossessions, and Abandonments


There are tax implications, but that only applies if you actually get foreclosed on. Withdrawals to prevent foreclosure have no additional tax benefit.

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Now since you were withdrawing from a 401k, there is a mandatory 20% withholding (meaning they send 20% to the IRS for you).

Given the amount you withdrew ($225,000) that would put you in a high bracket in and of itself. You'd include the distribution as part of your income.

2011 Tax Brackets

Nearly any way you file $225k of income puts you in the 33% bracket. And they withheld 20% for you, meaning you are responsible for the remaining 13%.

$225,000 * 13% = $29,250

And if the distribution occurred before you turned 59 1/2, you'd also owe an additional 10% = $22,500

Plus any state tax.

I'm sorry that you were given wrong information.

[MonkeyMama]

You've learned the hard way, but never take tax advice from a brokerage.

I've seen awful advice over the years. To be fair, they have a general working knowledge of taxes as it relates to investments, I am sure, but not a very thorough tax knowledge (& the tax code changes so rapidly that they often give out-dated advice, anyway). But people generally perceive brokerages to have tax knowledge. Just as much as they perceive tax advisors to have a wider investment or financial knowledge. The truth is that investors know investing, financial planners know financial planning, and tax professionals know taxes, and lawyers know law. There may be some overlap, but the advice you get from one won't be as top notch as someone who 100% focuses on that one area.

Lesson learned, in this case. But I think it bears repeating, if one person reads this and is saved from a situation like this.