One Decision That Can Cost Ten Thousand Dollars

Have you ever thought to yourself, “I’d like to owe the IRS ten thousand dollars?”  Find out how!

Let me share a conversation I had a few years ago with you.  Names and identifying details have been changed to protect me from the guilty.

Me, preparing tax returns:  Let’s see your paperwork… *shuffles paperwork* Oh, a 1099-R.  *turns pale*  Did you take some money out of your 401(k)?

Mr. Oblivious Client:  Yep.  $90,000.

Now, for those of you who aren’t as acquainted with 401(k)s, let me share some important details with you.  One, when you take your money out of a 401(k), the amount withdrawn is subject to taxes in the year it is withdrawn.  Two, if certain requirements are not met, there is a 10% tax penalty on top of that.*  So you could conceivably pay up to 54% of your savings in taxes (35% top federal tax bracket for 2010, plus 10% federal penalty, plus, let’s say, about 7% state and local tax.)  You can see why I turned pale.

Mr. Oblivious Client:  But I had them take out the taxes.

Me, groaning inwardly:  I see.

Now for critically important detail number three:  the call center folks at the 401(k) servicing company do not know your individual tax situation!  They have no idea how much they should withhold for your taxes.  You tell them to take out taxes, and they take out (generally) 20%, because that’s what the training manual says to do.  Then they say, there, we withheld taxes.  Nevermind that they withheld only 20%.  (What is that supposed to cover, anyway?  Ten percent federal and 10% penalty?  What about the state?  And what if you earn $8,376 or more (15% bracket, filing single for 2010?)  Ridiculous.)**

Me:  They didn’t withhold enough, I can tell you that already.  I think you’ll end up owing the IRS.  Let me see if there’s anything I can do.

Mr. Getting Nervous Client:  Ok…

Time passes…

Me, bracing myself:  Alright, taxes complete.  I have you owing a little over $12,000 to the IRS.

[Insert Mr. Enraged Client here.]

Now, how can we prevent this little drama, or something like it, from happening to you?  It only takes ten to fifteen minutes.  It called calling your tax person.  When you choose to do something that may have taxable consequences, such as:

  • Starting or closing a business
  • Becoming self-employed
  • Withdrawing or contributing funds to a retirement plan
  • divorcing, marrying, adding or subtracting children
  • A major spike in income (yay!) or deducible expenses (boo!)
  • And more!

Call you tax person.  Event storefront chains will answer their clients questions over the course of the year.  Doing this one simple step can save you some real injuries to your wallet.

*  If you think that’s bad, try withdrawing or rolling over a Simple IRA within the first two years from opening it.  Hello 25% penalty!  (There are certain exceptions, of course.)

**  Remember, don’t come to this blog for tax advice.  This is meant to entertain and persuade you to call your tax person for tax advice.  Remember, this blog is to entertainment as tax professional is to tax advice.

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