It’s important for all freelancers, solo entrepreneurs, and profit-seeking online hustlers to save up for tax season. Any side contractor income beyond $600 or so a year from one particular employer needs to be reported to the United States government for all recognized American citizens.
The easiest way to protect yourself from being audited or fined while keeping your supplemental income earnings is creating an IRA. If by the end of the year, the maximum IRA contribution has been reached then you can also open an independent 401k.
When I was making online income as a college student, I did not know IRAs and solo 401k plans existed. I could have contributed to both instead of paying thousands extra to taxes than I needed.
Thanks to my naivety in the subject, I lost a few thousand dollars to the taxman. See how financial literacy is important?
The big pro of opening a self-sponsored retirement account is being able to keep more of your dollar untaxed.
However, that money, though sheltered, is locked in until age 59 ½ without withdrawal penalties.
Withdrawing from any 401k early is a bad move for last resorts even if a dream house is on the line.
Any gains that the 401k has generated over the years practically vanished.
The employer automatically takes away your taxed bracket amount for the IRS before you even see the money. It’s taxed like regular income at your current income bracket in addition to any state income tax as it applies.
For the grand flourish, another 10% in just penalties is added on at the end of the year. The U.S. government really, really, really discourages anyone from cashing out their retirement plans.
Not everyone knows early withdrawal penalties or take the penalties seriously.
This is Uncle Sam we’re talking about – the one man that you should not owe.
Before thinking about withdrawing any income from any 401k just remember this particular story from a former workmate of mine, Mandy.
This is Mandy’s cautionary tale:
Mandy and her husband have been dreaming about purchasing their first home for years. Her husband is a fiberglass installer at a local contracting firm.
Her husband makes a healthy salary of around $65K a year and cost of living is low in their small Washington state town. They have two cars, two degrees and too high of a credit card balance. They were almost $90k in debt; mostly from a car loan and both of their student loans.
Even with a salary of $65,000 a year, with their debt load, ends are sometimes hard to meet so Mandy does what she can to help the household finances go a bit smoother.
Mandy and her husband lived comfortably in a small 2 bedroom apartment. It was all in an effort to save up money someday for a home in the suburbs.
After having a set of twins last year, Mandy found herself and her own growing family running out of space.
Babies give awesome wake-up calls.
In addition to being a full-time mom to twin toddlers, she started working from home. With her extra income babysitting neighbor kids among many other hustlings, they started tackling their debt ferociously using the debt snowball method.
It’s always absolutely incredible to see how some hustling can transform the basic foundation of so many people’s lives.
Charged with the rapidly forthcoming possibility of being debt free soon, Mandy and her husband were sideswiped by a surprise housing opportunity that came up in the neighborhood.
The house for sale was not too far from Mandy’s mom which was perfect.
The house itself sits on a corner lot and had a sizable yard. The sellers were on good terms with Mandy’s mother. In fact, the sellers agreed to fix up minor issues even before the official inspection.
The older woman seller wanted her house to be passed down to a good family that will treat it right so her agent informed them that if they can put in a down payment, the house would be theirs.
The decision was to find and scrimp together the down payment as this opportunity was too rare to pass up!
Suddenly, they were physically cash-strapped. They need to come up with a downpayment ASAP.
Mandy then realized that her former employed had mailed her a 401k check. Just enough for that down payment! Since it was simply a check, money right in hand, Mandy cashed out her family’s 401k for the house down payment without understanding the fine print of taking out the 401k early.
Big Time Oops
Eeeek not good. OK, basically some employers will mail out a 401k check because there was not enough money in there (usually funded plans under $5,000 are released) for the company to keep the account.
Plus sometimes smaller company HR firms do not offer rollover as a viable option depending on the situation.
In any of these situations, it’s imperative for everyone to understand what to do because this information just isn’t available for the general public. It doesn’t matter if you’re self-employed or employed with a company, you are responsible for your own paperwork.
What Mandy and her husband needed to do was indirectly transfer that check to a personal IRA.
They needed to get that money into an IRA within 60 days in order to avoid the tax penalties. Any time after the 60-day mark is too late and you will be responsible for withdrawal penalties.
You can open an IRA at any bank or brokerage that supports it. Both Fidelity and Vanguard are great options.
Typically a direct rollover to an IRA is the simpler of the two. You contact your company’s HR department and follow their guide. Moreover, there will be some paperwork and confirmation required but there’s less legwork involved for the employee overall.
Unfortunately, Uncle Sam is a hard man when it comes to accidents like this. Many Americans are not financially literate and there’s no reason to punish what a person does not know in the first place.
But now to look at the bright side – they did get that dream house! You can argue that in the long run, it wasn’t that bad. The amount was relatively forgivable as well in contrast to learning this lesson on a potentially much higher figure. The tax bill will be about $1,500 which they can clear as long as they are diligent. They are back on the debt snowball now and slowly digging out again.
Do you think Mandy and her husband should have waited on the house? Are the retirement 401k and IRA rollovers too complicated? Are the tax penalties too harsh? Should there be exceptions to withdrawing from a 401k early?
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