If you take a large distribution from your IRA or 401(k) plan, especially early in the year, your tax refund could essentially disappear overnight.
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Not because a withdrawal somehow negates a tax refund, but simply because it can dramatically increase your tax liability, potentially exceeding the check you get back from the government.
How Distributions Can Increase Tax Liabilities
Withdrawals from pretax retirement plans, such as traditional IRAs and 401(k) plans, are included in your taxable income, per the IRS. Because the U.S. tax system is progressive, if you take a large distribution, you may end up in a higher tax bracket.
Although this won’t specifically reduce the size of your refund, it does increase the tax you’re required to pay. In some cases, this may increase your tax liability to the point that it exceeds the amount of your refund.
If your adjusted gross income goes up, it may have additional negative effects, such as increasing the taxes you owe on Social Security benefits or reducing credits you might otherwise qualify for.
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Timing Can Have an Effect as Well
The U.S. operates on a pay-as-you-go tax basis, according to the IRS. You’re responsible for paying taxes throughout the year as you receive income. Retirement plan distributions often have default withholding rates that may not fully cover the amount of tax you owe, with 10% often being the standard rate. If you don’t pay all of the tax that you owe, you may trigger estimated tax penalties, taking an additional bite out of your refund amount.
Even Required Minimum Distributions Can Cause Tax Issues
Beginning at age 73, retirees must take required minimum distributions (RMDs) from most traditional retirement accounts, which can increase taxable income even if the funds are not needed for spending, per the IRS. In some cases, these RMDs can push retirees into higher tax brackets or increase Medicare premiums, according to Kiplinger.
How To Avoid Refund Surprises
A retirement plan distribution can’t technically make your tax refund “disappear.” However, it can increase your tax liabilities to the point that they exceed the amount of your refund.
Here are some steps to help minimize the impact:
- Talk with a tax expert about available strategies.
- Spread withdrawals across multiple tax years, if possible.
- Ensure that you withhold enough income tax from your retirement plan distributions.
- Track your income throughout the year to help you estimate your tax liability.
- Plan your RMD timing carefully once you begin withdrawals.
The best way to avoid unexpected surprises when it comes to your tax liability is to think holistically. Thoughtful planning around income, distributions, deductible expenses and tax credits can help you keep more of what you earn and avoid unexpected tax bills.
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This article originally appeared on GOBankingRates.com: The Retirement Income Change That Makes Your Tax Refund Disappear — Sometimes Overnight
