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Shifting severance pay to a 401(k)


Dear Tax Talk,
I'm about to receive a lump sum severance payment for being laid off through an acquisition. I have another job already and had planned on using the bulk of the money as a down payment on a home (condo). Can I direct a portion of the severance to my 401(k)? I don't have access to a 401(k) in my new job for six months and had planned on maxing out my $11,000 limit in January 2005 (under my old job) with a portion of the severance. Can I then roll that into an IRA after I leave the job and take it out as a down payment on a house? Thanks. -- Allen

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Dear Allen,
Your plan of action needs a little perspective.

If you'll be deferring money into your 401(k) only to later withdraw it in the same year from an IRA, you haven't gained much since you'll be taxed on the withdrawal.

While it's true that you can withdraw up to $10,000 in funds from an IRA to buy a first home (and tax law interprets "first home" to mean that you haven't owned one in two years), you have to pay income tax on the withdrawal. The only thing you avoid is the 10 percent penalty on early withdrawals. So by putting $10,000 into the 401(k) and later withdrawing it for the home purchase, you're in the same position as if you did not make the contribution to begin with.

For example, assume in January you get $100,000 in severance and put $14,000 (the 2005 limit on 401(k) contributions) into the 401(k), leaving you $86,000 in taxable income. Then you transfer the 401(k) money into a rollover IRA. Later in 2005, if you withdraw $10,000 from the IRA, your taxable income goes up to $96,000, which is the same as if you only deferred $4,000 into the 401(k).

My advice is to keep it simple and leave out the money you need for the house.

-- Posted: Dec. 10, 2004




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