Friday, July 20, 2012

How Much Tax Do You Pay on a Cashed Out 403(b)?

Cashing out your 403(b) might lead to hefty taxes and penalties

Source: StockMonkeys (Flickr)
A 403(b) is a qualified group retirement plan that's similar to a 401(k) but offered by nonprofit organizations like churches and schools.

If you work for this type of organization and participate in the plan, understanding the consequences of cashing out your account can help you prepare for the future.

Qualified Plan Contributions

Money you contribute to a 403(b) plan is automatically deducted from your paycheck; state and federal income taxes are deducted from the remaining balance of your earnings. You still owe taxes on the money in your 403(b), but the Internal Revenue Service allows you to defer paying them until a later date.

When you cash out a 403(b), you will pay taxes on the money you receive at whatever your current income tax bracket is at that time.

Eligible Retirement Distribution

In most cases, you can't withdraw money from your 403(b) until you are at least 59 1/2 years old. The IRS discusses the rules regarding permissible distributions in Chapter 8 of Publication 571 and explains that money you receive from a 403(b) account is fully taxable as ordinary income.

If you cash out your account and take the entire balance in a single lump sum, that amount will be considered income for the year you receive the money. When combined with other taxable earnings, your cashed out 403(b) may raise you to a higher tax bracket.

Early Withdrawal Penalty

In Topic 558, the IRS describes early distributions as money you receive from qualified retirement plans before you are 59 1/2 years old. Cashing out your 403(b) before you reach 59 1/2 typically results in penalties.

Aside from ordinary income taxes due on the money you receive, you must also pay a 10 percent early withdrawal penalty. If your 403(b) contains a sizable balance, these taxes and penalties might significantly reduce how much money you actually receive when you cash out.

Annuity Surrender Charges

Many 403(b) plans offer fixed and variable annuities as investment options to plan participants. Annuities are retirement investment vehicles managed by life insurance companies. Most annuities have their own penalties and fees called surrender charges that are assessed if you withdraw money too soon.

Surrender charges vary in size and duration and commonly range from 7 to 10 percent and last for seven to 10 years. These annuity penalties are separate from income taxes and IRS early withdrawal penalties and may dramatically reduce the balance in your account if you cash out while surrender charges remain in effect.

Article originally published on (07/20/2012)

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