(b)lines Ask the Experts – Difference Between Plan Distribution Withholding and Actual Taxes Paid

“What is the difference between the 20% withholding for most retirement plan distributions (i.e., eligible rollover distributions) and the actual taxes paid? My 403(b) plan participants (current and former) who take distributions seem to be thoroughly confused on this issue, so any assistance the Experts can provide would be greatly appreciated!”

Stacey Bradford, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

Indeed we can provide assistance! In order to best explain the difference between withholding and actual taxes paid, the Experts often use the analogy to how a participant gets paid by his/her employer. When an employee is paid each pay period, a certain amount is withheld from each check for payment of federal, state and local taxes. However, this is NOT the actual amount of taxes an employee owes; that amount of taxes is NOT figured out until an employee files his/her personal income tax return. If the amounts that have been withheld are GREATER than the amount of taxes an employee actually owes on his or her income, then the employee receives a tax refund. If the amounts that have been withheld are LESS than the taxes the employee owes on his or her income, then the employee owes the IRS additional taxes at the time of filing.

Plan distributions work in a similar fashion; at the time of distribution, a portion of the distribution is generally withheld for the payment of taxes. For eligible rollover distributions (e.g., lump sums), it is a mandatory 20% withholding, and a participant cannot opt out of this 20% withholding. There are exceptions to this mandatory withholding in the case of non-eligible rollover distributions, for example, when a participant withdraws elective deferrals in the event of financial hardship, or to the extent the distribution is a required minimum distribution. In those cases, a participant may generally elect a withholding amount; many recordkeepers will withhold 10% unless a participant elects otherwise.  Separately, for annuity payments, wage withholding applies.

The plan distribution is then added to an employee’s income for tax purposes. If 20% was withheld from the distribution, and the employee actually owes, say, 40% tax on that distribution, he/she would owe an additional 20% of that distribution at tax time to pay outstanding taxes on that distribution. Of course, if the employee only owes 10% on the distribution, he/she would be entitled to an additional refund (or credit against taxes otherwise owed) equal to 10% of the distribution. However, many employees, particularly ones who are younger than 59 1/2 when they take a distribution, end up owing additional taxes on distributions at filing time. The reasons for this are a) there is a 10% tax penalty on distributions if the employee is younger than 59 1/2, and b) the income from the distribution can push the employee into a higher income tax bracket, which means that a higher tax rate would apply to the distribution (this can be a particular problem with large distributions).

Of course, a cash distribution can be rolled over by the distributee within 60 days as well, subject to certain rules. In that event, the 20% withheld will still generally be taxable unless the distributee makes it up by finding other cash to rollover within the required period—that is why a direct rollover to the new plan or IRA is often preferable for the distributee.

Therefore, in order to address any employee confusion, you should explain to them that withdrawals are similar to receiving the taxable income that they receive in a paycheck (only with an additional 10% penalty tax if they are younger than 59 1/2). Thus, any plan distributions should be considered when tax planning for the year to avoid having to pay additional taxes at the end of the year. In high tax states, this could be as high as 50% of the distribution amount, which is why distributions prior to retirement can be quite disadvantageous from a tax perspective.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.