I have never been one to enjoy the scary aspects of Halloween. Trick or treating and carving jack-o’-lanterns are Halloween activities that are much more appealing to me, but I know there are some of you who can’t wait to visit haunted houses and watch scary movies.
What’s scarier to me than any zombie movie, though, are the frightening mistakes I sometimes see taxpayers make. Horror stories don’t always have to have ghosts and monsters. Sometimes they involve things as simple as your retirement account. Take a look at the terrifying examples below to make sure that you’re not slipping into the same nightmare as these investors.
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The New Business That Cost a Scary Amount of Taxes
I met with a new investor this year named Sean. He provided a 1099-R form showing a $50k distribution from his IRA. He was only in his 40s so I asked him why he received this, as it would be subject to both taxes and a 10% penalty if he didn’t meet one of the penalty exemptions. He responded that he used the distribution to start a new business. This is a mistake that I see several times a year. Many investors fail to realize that IRAs do not work like savings accounts. Money can be rolled from one retirement account to another, but once money is taken out of the account as distributions, it general becomes taxable. If it is not done for a valid reason, it may also be subject to a 10% penalty.
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Because Sean was in a 37% tax bracket overall, he owed over $18k in taxes on the $50k of income plus $5k of penalties for early distributions. A scary amount to pay for a mistake that may have been avoided with some proper planning.
The College Tuition Horror Story
Rebecca set up a Solo(k) account a few years ago for her fix and flip business, and she has diligently contributed the maximum that she could to this account ever since. However, this year it was shocking to see that she took a $30k distribution from the account she had worked so hard to build. She said that she thought she could take a distribution out penalty-free if it was for higher education expenses. As such, she decided to take a distribution to pay for her son’s first year of college.
While there are some exceptions to the 10% early withdrawal penalty, they do NOT apply to Solo(k)s and 401(k)s. These rules are only for IRAs, and even then, there are very specific rules that need to be met to take these early distributions penalty-free. Rebecca’s mistake ended up costing her almost $9k in tax due to her 29% tax rate plus another $3k in penalties, over a third of her son’s first year of college costs.
The Tale of the Terrifying Tax Bill
Several years ago, a client of mine, Elise, called us in an absolute panic. She saw her tax bill and just about had a heart attack. Her tax bill was so high because she had received a 1099-R for an early retirement distribution, so not only did she have to pick up the income, she also had to pay the 10% penalty. Her argument was that it was not a distribution. It was a loan from her 401(k) that she used for real estate investing.
After more investigating, she found out that although she had originally taken a $50k loan from her 401(k) and had made payments for a few months, she stopped making her loan payments when her rentals started to go south. Once the term of her loan had ended, her retirement custodian had issued her a 1099-R for the $40k balance that was unpaid. It was now an early distribution and not a loan. What Elise learned the hard way was that if loans are not paid back timely, they become taxable distributions. To add insult to injury, if you are under 59½, then the 10% penalty is added to that total.
The Vacation Home Nightmare
Recently, a client named Jared came to me with what he thought was a fantastic investment. He had just purchased this perfect home right on the beach in Orange County and he had used his IRA funds to do it.
I asked him if he planned on having a full year renter or if he was going to do vacation rentals with the property. Jared’s response was neither. He was going to use it as a vacation home for his family. I had to stop him right there. This is a huge no-no when it comes to IRAs. If you purchase a house with your IRA, you cannot benefit from the property personally. It must be used solely to generate income for retirement. It cannot be your primary home, it cannot be your vacation home, and it cannot be a second home where you let your kids or parents live rent-free.
Related: The 6 Basic Principles (& 3 Common Myths) of Investing For Retirement
Jared was extremely upset to find out that after finding his dream vacation home and going through all the work to purchase and furnish it with his IRA, he was not able to use it. His options now were to either attempt to rent it out — or sell it and find a different investment. Make sure that you don’t make the same mistake as Jared! Any investments purchased with your IRA must not currently benefit you or your immediately family in any way.
Retirement accounts were created for the purpose of saving for retirement, and they want to ensure that you do just that. If you want to put money in an investment that is prohibited by the retirement tax law, then an IRA is probably not the best place to deposit that money. Always consult with your tax advisor BEFORE you take a loan or distribution to make sure that you understand the potential taxes and penalties associated with the transactions or else you could find yourself in your own tax nightmare.
Do you have any retirement account horror stories to tell?
Share them below!