Beware of Government Bearing Gifts--You May Be Taxed

Q: Many years ago, I put $20,000 into an individual retirement account and purchased stock with it. The stock has done well and the account is now worth more than $140,000. May I withdraw all the funds at once or must I take it out in annual increments? I am 68, so age is not an issue.

--R.L.G.

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A: The U.S. government, ever searching for new and creative ways to lure Americans into withdrawing a part of the trillions of dollars that have accumulated in tax-deferred retirement accounts, is offering to waive for three years (1997, ’98 and ‘99) the 15% penalty on large withdrawals from 401(k), IRA and certain other tax-deferred retirement plans.

But just because the offer has been extended is no reason to feel any pressure to accept it. In your case in particular, the offer has no significance because the 15% penalty would have affected withdrawals of more than $160,000 this year.

Still, let’s examine this ostensible gift to American taxpayers. The fact is that once you make a withdrawal from your 401(k) or IRA account, those funds will no longer generate tax-deferred earnings. And that, of course, is the primary reason you have the account.

According to one analysis, money withdrawn from a tax-deferred retirement plan would have to earn more than twice as much in an investment outside the plan as it had been generating within it to make the transfer worthwhile to the taxpayer. The reason not only hinges on the loss of tax-deferred earnings. Remember, once you withdraw the funds from the sheltered account, they are immediately subject to ordinary income taxes, so your nest egg will shrink by at least the amount of your combined state and federal tax rates.

This, of course, is precisely the reason the government has offered to waive the excise tax for three years. It wants taxpayers to withdraw some of the money from their tax-sheltered accounts so they can be taxed. Somewhere, in some piece of legislation, additional spending was offset by the government’s prediction that it could lure a sufficient number of Americans into taking the “penalty-free” offer.

That said, it should also be noted that for some people this offer makes sense. Who? Our experts say the best candidates are taxpayers with big-balance IRA or 401(k) accounts who are already past age 70 1/2 and must already make annual withdrawals of substantial size. But even these taxpayers may want to wait until 1999 to make the big withdrawal, in order to allow their accounts to build up as much tax-deferred income as possible.

Other possible beneficiaries of Congress’ offer include older taxpayers who want to tap into their retirement accounts to cover large expenses, or people who don’t expect to live past 1999. (The waiver does not cover retirement accounts left in estates.)

By the way, remember that the government’s waiver of the excess-distribution penalty does not affect the 10% penalty for withdrawals made before a taxpayer turns age 59 1/2. That remains unchanged.

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Q: I have an adult daughter living with me. She is a full-time student and is completely dependent on me. She has some earnings from a job and some dividends. She files a tax return but does not have to pay any taxes. May I claim her as a dependent?

--H.A.G.

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A: You may claim your adult daughter as a dependent provided that both of you meet the government’s qualifications. As your daughter and someone for whom you provide more than 50% support, she meets the critical relationship and support tests. We’ll assume she is a U.S. citizen or national and is single or, if married, does not file a joint tax return with her spouse.

The final tests will perhaps prove the most difficult to meet. How old is your daughter? And how much is her gross income? If she is 23 or younger, she meets another key criterion because she is, as you say, a full-time student. However, if she is 24 or older, her student status doesn’t matter. The issue becomes gross income. For 1996, you could claim an adult child as a dependent only if his or her gross income was less than $2,550. This figure will be adjusted for inflation for 1997, but even so, it won’t increase much.

In the end, she will qualify as a dependent for you only if her income is in the neighborhood of $225 per month, an amount that hardly seems possible if she has “some earnings . . . and some dividends.”

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.