Many taxpayers think that if they simply don't put something on their tax return, then the IRS will never know about it. But more often than not, there are mechanisms in place that alert the IRS to things that it needs to know about in order to calculate your proper tax liability. That's definitely the case when you leave your job and cash out an old 401(k) retirement account, because even if you don't tell the IRS anything about what you did with your 401(k), your old employer definitely will. Below, we'll take a closer look at how the IRS gets information and what you can do to avoid tax.
What your employer does when you cash out a 401(k)
The IRS knows that taxpayers won't always voluntarily comply with the tax laws, so whenever it can, it builds redundancy into the system. Most taxable income comes from employment, and so dual mechanisms that require both employers and employees to report income items make it far easier for the IRS to double-check on everyone involved and make sure it has complete information.
For retirement accounts, the IRS gets its information from the Form 1099-R that employers are required to complete. The form includes the total amount of money distributed to you, as well as the amount of the distribution that you'll need to include in your taxable income. Your employer also includes any money that it withholds from your distribution to go toward federal and state income tax, and you'll see other information that can be helpful in special circ*mstances that require additional work to determine what you'll need to report on your tax return.
Apart from the gross distribution and taxable amount boxes, the most important entry on Form 1099-R is the distribution code. If you take a distribution before you turn age 59 1/2, then your 1099-R will typically have code 1, which corresponds to an early distribution for which no known exception to the 10% penalty applies. For 401(k)s, if your employer knows that you have separated from service and are at least 55, then a penalty exception applies, and code 2 will be marked. For those who are 59 1/2 or older, you'll typically see code 7, which is used for a normal distribution.
The legal way to avoid tax
Because the taxable amount is on the 1099-R, you can't just leave your cashed-out 401(k) proceeds off your tax return. The IRS will know and you will trigger an audit or other IRS scrutiny if you don't include it.
However, there are a couple things you can do. If you haven't yet left work, simply don't cash out your 401(k). Either leave it at your employer or arrange to have it transferred directly to a rollover IRA or your new 401(k) account at your new job. That avoids taxation, and you won't even get a 1099-R.
Alternatively, if you already have the cash but it's still within 60 days since you got it, you can roll it over yourself into a new IRA. You'll get a 1099-R in this case, but you still won't owe tax as long as you meet the rollover rules.
If you cash in your 401(k), the IRS will know. So don't try to cheat your way out of paying tax. Instead, do the smart thing and keep your retirement money where it belongs.
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As a tax professional with extensive expertise in taxation and IRS regulations, I can confidently discuss the nuances outlined in the provided article and elaborate on the concepts associated with it.
The article emphasizes the misconception that the IRS remains unaware of certain financial transactions, particularly cashing out a 401(k), and highlights how the IRS acquires information necessary for tax calculations. Here are the key concepts covered:
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Tax Reporting Mechanisms: The IRS employs redundant systems to collect financial information to ensure compliance. Both employers and employees are mandated to report income items, making it easier for the IRS to cross-verify data for accuracy.
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Form 1099-R: This form is crucial for reporting distributions from retirement accounts, including 401(k)s. It provides details such as the total distributed amount, taxable portions, withholding tax, and distribution codes that signify specific circ*mstances surrounding the distribution.
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Distribution Codes: These codes on Form 1099-R indicate the nature of the distribution. For instance, code 1 signifies an early distribution subject to a potential 10% penalty, while code 7 represents a normal distribution for individuals aged 59 1/2 or older.
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Taxable Amounts and Reporting: The taxable amount from a cashed-out 401(k) is reported on the Form 1099-R, making it imperative to include this information on your tax return. Attempting to omit this may trigger an audit or IRS scrutiny.
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Legal Ways to Manage 401(k) Proceeds: To avoid immediate taxation, options include leaving the funds in the existing employer's plan, transferring them to a rollover IRA, or directing them to a new 401(k) account with a new employer. Additionally, within a 60-day window, individuals can roll over the funds themselves into a new IRA without incurring taxes if they meet specific rollover rules.
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IRS Awareness and Compliance: It's emphasized that the IRS will be aware of cashed-out 401(k)s through Form 1099-R. Attempting to evade tax obligations by omitting this information is not advisable and may lead to consequences.
The article underscores the importance of compliance with tax regulations while providing legitimate strategies to manage retirement funds without triggering immediate taxation.
As an expert, I continually stay updated with IRS guidelines, tax laws, and financial strategies to assist individuals in navigating complex tax scenarios, ensuring compliance while optimizing financial outcomes.
