Question from @gennatay – IRA: I borrowed from my IRA to pay bills? The bank withholds 10% automatically for feds. How does this affect me when I file.
Borrowing from retirement plans
Unfortunately IRA participants cannot borrow money from their IRA like taking a loan. Unlike other retirement plans such as a 401k, IRAs are not “loan flexible”. If you use your IRA as collateral for a loan this creates a deemed distribution, which will create a taxable event. Generally, assigning or pledging an IRA or other retirement plan causes a deemed distribution. Deemed distributions cause benefits to become taxable despite not taking an actual distribution.
There is a work-around that allows an IRA participant to borrow money for a limited amount of time. You can access your IRA money by using the 60-day rollover provision. Make sure to review the 60-day rollover rules so you don’t risk violating them. When you are eligible, you can distribute funds in your IRA with the freedom to use them how you want. You must re-deposit the amount of your withdraw within 60 days. This rule allows you to temporarily access your IRA funds without penalty or tax. Just make sure you review the rules so you know you are eligible.
Retirement plan withholdings on distributions
IRA distributions are subject to withholdings of 10%, but Sec. 3405(b)(2) allows the recipient to elect out of any withholding. Consequently, IRA custodians will default your federal withholding rate at 10%, but you should have an option to opt-out of the withholding, or change the percentage.
Qualified Retirement Plans like your 401k are subject to withholdings of 20%. In this case, the recipient cannot elect out of the withholding. Direct rollovers to retirement plans are not subject to the 20% withholding. We recommend that participants perform a direct rollover to an IRA when they need to withdraw funds from their retirement account without a mandatory withholding. By doing this, you can elect out of a withholding because your money is now coming from an IRA.
Each state can have different withholding requirements. Some states will require a withholding on IRA distributions. Remember, when a participant younger than 59 1/2 withdraws money from a retirement account they may be subject to a 10% penalty on the taxable portion. Federal income taxes will still apply to any pre-tax dollars as well.
Withholdings and filing my tax return
Distributions from a retirement plan or IRA are taxed at your ordinary income tax rates, not a flat tax. When your taxes are prepared, the withdraws from your IRA will be subject to a specific amount of tax, which is a result of your unique tax situation. The tax liability from your IRA withdraw is part of your overall tax liability. The amount you withheld is also part of your total withholdings during the year. Because your total withholdings are applied to your final tax liability, the difference results in how much you owe the IRS, or how much they owe you!
You withdraw $50,000 from your IRA and withhold $5,000, that $5,000 is sent to the IRS as a withholding toward the tax you will owe. The tax liability on your IRA withdraw is $10,000. You under-withheld by $5,000, which affects the rest of your tax liability or refund. If all the other activity on your tax return results in $2,000 “refund position”, the net total you owe will be $3,000.
Filing your taxes with IRA withdraws will not always be this straightforward, but this is a general explanation of how the withholdings affect you when you file. Under-withholding can result in penalties. Make sure you consult with your tax professional about the amount he recommends you withhold.