January 4, 2021
How to Avoid Tax Penalties in 2021
Penalties like sneaking up on people. Don’t let them get you! Take our tips on making the most of your retirement contributions and avoiding the penalties that can come along with them.
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Whether you’ve cashed out a 401(k) this year or left your IRA alone, it’s always critical to make sure you’re avoiding the penalties that can come from making moves with your retirement savings. It’s especially important to keep this in mind as you file your 2020 taxes, since the CARES Act and pandemic have made some alterations to the typical penalties.
The fine print can be a little difficult to sift through, which is exactly why we’ve broken it down for you in the following guide. Check out these guidelines to make sure your 2021 has zero penalties.
Avoiding a Penalty on Your RMD
If you have an IRA, SEP, or SIMPLE retirement savings account, you may have already started dipping into it—many people are eager to as soon as they’re able. Others prefer to hold off, but there comes an age where you’re forced to take a required minimum distribution, or an RMD. If you don’t take the RMD, you can face up to a 50% penalty on the amount that should have been withdrawn.
That age used to be 72. But thanks to recent legislation as well as pandemic measures, those guidelines have changed. First, the SECURE Act may have placed you on the cusp of the age limit. If you turned 70 ½ in 2020, you would typically have to take an RMD by April 1 of the year after you turn 72, and then another one by December 31 of that year.
Additionally for 2020, however, the CARES Act suspended the penalties for not taking RMDs in 2020. This may benefit you in a few different ways. For one, your money may have more time to grow in the market before you have to pull some out. Plus, if you had already preferred to leave that cash alone, you won’t be taxed on the money you would have been forced to withdraw. Just keep in mind that for 2021, the CARES Act suspension will not apply, so if applicable, you should be back to taking your RMD like usual to avoid penalties.
Of course, if you’d still like to take out the amount of your RMD, you can. Just know you won’t be penalized if you didn’t take it in 2020.
Maximizing (but Not Overstuffing!) Your 401(k)
If you’re able, this time of year is a great time to make sure you’ve maximized your retirement savings. If you’re under the age of 50, for both 2020 and 2021, the maximum annual contribution allowed to your 401(k) is $19,500, up slightly from previous years. If you’re 50 or over, you’re able to start making catch-up contributions to boost your savings a little before your retirement years. In 2021, you can add an additional $6,500 to your 401(k) as a catch-up.
Maybe you’ve just finished off paying a loan, or you may have just picked up a side gig that allowed you to bring in a little extra income. Consider moving some of that newfound cash to max out your 401(k) so that it grows in the years ahead.
But make sure you’re sticking to the limits! Some people accidentally put in too much, leading to a penalty for excess deferral. The penalty is essentially getting double taxed, because in addition to the excess amount being included in your current taxable income, you’ll also be taxed on the excess funds when you eventually withdraw your savings.
If you’ve found that you’ve contributed too much in 2020, you still have time to reverse the move and avoid a penalty. In order to do so, you’ll have to take any excess amount (including anything those extra funds may have already earned!) out of your account. This removal is called a corrective distribution, and you have until April 15, 2021 (the 2020 tax filing deadline) to do it.
Avoid Penalties on Your 401(k)
Of course, not everyone is always able to max out their 401(k), especially in years like 2020 with so much economic uncertainty. If you have been tempted to dip into yours for emergency funds, you would typically face a penalty. Though, once again, the CARES Act is slightly changing that for 2020.
Generally, if you take money out of your 401(k) before you turn 59 ½, you’ll face a 10% penalty on the amount you withdraw. There are always some exceptions to this rule, but for 2020, the CARES Act has made pandemic-related financial stress one of those exceptions in order to give some extra relief to people who need access to cash.
If you, your spouse, or your dependent has been diagnosed with COVID-19, you qualify to take a penalty-free withdrawal of up to $100,000 on a 401(k), IRA, or 403(b). You also qualify if you’ve faced “adverse financial consequences” thanks to losing your job, getting furloughed, having your hours cut or a job offer rescinded, closing your own business, or having to give up work due to a lack of childcare because of the pandemic.
It’s possible that even if you fall into the above category, you may not want to dip into your 401(k) just yet, as it’s wise to give that money time to grow for your retirement years.
But keep in mind that even though you won’t pay a penalty, you will still pay federal income taxes on that withdrawal. You can claim the entire amount for your 2020 taxes, or you can choose to spread it equally between your 2020, 2021, and 2022 tax returns. For instance, if you withdrew $12,000 of your 401(k) in 2020, you could choose to be taxed on $4,000 per year on your next three tax returns. Or, to avoid the taxation, you can pay back the amount within three years. Using tax software like TurboTax, H&R Block, and TaxSlayer can help you determine which option makes the most sense for you.
Heading Into 2021 With a Plan
Pandemic legislation has helped to cut back on the amount of penalties possible for 2020, but there’s no indication those measures will extend into 2021. Keep that in mind as you make your financial plans for the year ahead so that you don’t get caught with fees or extra taxes you could have avoided.
Silvur’s Retirement Score calculator can also be a great tool to help you plan for 2021. By entering your information and taking a look at your score, you can see how you’re currently situated for retirement, think about the ways you might be able to put more funds toward your golden years, and make the plans that will help you walk into retirement with confidence and excitement.