How To Avoid The 20% Withholding Trap!

With all of the complex rules surrounding your 401k or your company sponsored retirement plans it's no wonder people end up paying taxes and penalties they didn't think they would have to. You have probably heard of the 20% withholding requirement and most plans consider this to be a mandatory part of doing business. However this withholding could cause some serious problems and if you read on you will find out that it is not as mandatory as you thought.

Most company sponsored retirement plans require that every time you take money out you must withhold 20% for taxes. So if you take a $10,000 distribution you may only get a check for $8,000. The good news is that the $2,000 is not lost it has just been sent to the IRS on your behalf. The bad news is that you get less money now and you are withholding taxes when you may not even owe any. Think about this. If you are laid off or out of work for an extended time what tax bracket are you in? If you have been collecting unemployment for the last 12 months and now it has run dry might you be in a lower tax bracket? And what if you really need the full $10,000 now and figure you will be in a better position to pay the taxes by next April when they will be due? Or lastly what if you just don't like the idea of paying your tax ahead of time and would much rather use ALL or YOUR money now and pay your taxes ONLY when they are due and not one minute sooner?

I will tell you how to avoid this so called "mandatory" rule in a minute but first let me tell you one more problem it creates. Did you know that if you do a 60 day rollover of your 401k plan into an IRA and you let them take the mandatory 20% withholding you will owe FULL TAX AND PENALTY on that money? For example, if you take a $100,000 distribution from your company plan to reinvest into an IRA they will withhold $20,000. Because you can now only reinvest $80,000 into your new IRA you will be short $20,000 on your 60 day rollover and FULL TAX AND PENALTY will be due on that $20,000 they forced you to withhold. You are probably thinking that this is not fair. After all you are entitled to roll over the whole amount and pay no tax, and it was not even your idea to withhold any money. If there was a way to avoid this problem wouldn't you want to know how, than read on...

Fortunately there is a way around these problems but chances are your human resource person will never tell you about it, nor will the company holding on to your funds. What you will useually hear is that the withholding is mandatory and that there is nothing they can do. Well here is how you fix this. Instead of doing a 60day rollover or taking a distribution directly from your company plan you TRANSFER your company plan to an IRA first. The key word here is TRANSFER. What you can do instead is called a "trustee to trustee transfer" or a "direct rollover". Doing a TRANSFER instead of a 60 Day Rollover will avoid the 20% withholding problem and once you have your money in an IRA you will have much more freedom to do with your money what you wish.