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The Guy Behind the Tree
The Guy Behind the Tree, Experienced Investor & Financier
Category: Tax
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If I pay off my car loan, can I claim that on taxes

Customer Question

I am thinking about withdrawing some money from my 401k to pay off the rest of my car loan ($10,000) which currently costs $408.00 a month. I need the additional money per month, but want to make sure that I don't have to claim that as income and can file that on my tax return.
Submitted: 7 years ago.
Category: Tax
Expert:  The Guy Behind the Tree replied 7 years ago.
Money withdrawn for this purpose from a 401(K) will be taxed as regular income. Some 10% with be withheld as a penalty, and 20% will be withheld for ordinary income tax, which you will account for next April.

Here are the rules:

*****

A hardship withdrawal is not like a plan loan. The withdrawal may be difficult to get, and costly if you receive it. Your 401k is meant to provide retirement income. It should be a last-resort source of cash for current expenses.

Knowing that workers would resist putting aside money for decades with no chance to access it, IRS rules allow plan withdrawals in a limited number of hardship situations. To further discourage early withdrawals, in some cases the IRS imposes a hefty financial penalty.

Two types of hardship withdrawals are permitted from 401k plans. One is called a financial hardship withdrawal. It is subject to applicable income taxes and a 10 percent early withdrawal penalty if you are younger than 59 1/2. These costs are significant.

The other is a penalty-free withdrawal made under Section 72(t) of the Internal Revenue Code. With this, you pay applicable income taxes but not an early withdrawal penalty.

Financial hardship withdrawals are allowed for the following reasons:

    * to buy a primary residence (the most common reason folks take hardship withdrawals according to the Investment Company Institute)
    * to prevent foreclosure or eviction from your home
    * to pay college tuition for yourself or a dependent, provided the tuition is due within the next 12 months
    * to pay unreimbursed medical expenses for you or your dependents

You may qualify to take a penalty-free withdrawal if you meet one of the following exceptions:

    * You become totally disabled.
    * You are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
    * You are required by court order to give the money to your divorced spouse, a child, or a dependent.
    * You are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
    * You are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59 1/2, whichever is longer.)

Employers are not required to offer either type of hardship withdrawal, so you should check with your employer to see which type, if any, is available to you.

This means that your financial hardship letter should set forth the facts of your situation. It doesn't have to be fancy language and it doesn't have to be lengthy. Just "tell it like it is" in your own words. Address it to your employer - have it delivered by "Certified Mail-Return Receipt" or by a courier like Fedex where you can confirm delivery. You can also deliver it in person, just have the personnel or finance office sign for it. Send a copy, also by Certified Mail, to the Trustee. If your employer has a form for requesting withdrawal, complete the form too.

Once you take the money out, you can't put it back in. You lose for life the tax advantage for the withdrawn funds.

Non-Hardship Withdrawals

Not every plan allows non-hardship withdrawals. If yours does, you have an opportunity to take money out of your account and redistribute it as you see fit. Generally the best bet is to roll the amount into an IRA. That way you avoid taxes, and you have a larger range of investment options, usually with lower administrative fees. Rollovers made directly to the owner of the 401(k) must be reinvested in a qualified plan within 60 days or be faced with a 10% penalty.

Source: 401khelpcenter.com
Customer: replied 7 years ago.
What I'm actually trying to find out is if I pay off my car loan $10,000.00, is there somewhere on my taxes for 2007 that I can report that the $10,000.00 went to my car loan so that it does not count as income?
Expert:  The Guy Behind the Tree replied 7 years ago.
In a word, "no".

It actually is "income" for IRS purposes. What you do with that income doesn't change it's status as income.

It is income because the funds in your 401(K) are "before tax" funds - you've not yet paid income tax on them.
Customer: replied 7 years ago.
My situation is that I quit my job of seven years in Oct. 2006. I had to take money out in January 2007 since I did not find a job until March. I had them cover taxes on the money that I withdrew, but did not fill out a hardship form. The job I have now does not pay as much, and I had to make another withdrawal in June 2007 which was the same amount $10,000.00 total($8000.00 cash and $2000.00 for taxes). I own a house that I pay a monthly mortgage of $1291 a month. I don't think I'm being charged a penalty, but how can I be sure?

Also, I debated refinancing my mortgage to get caught-up with bills, but I'm not sure that's the best thing to do. I'm trying to find a way to have extra money each month and thought paying off my car loan would be the best way to do it, but now I'm not sure. Any advice?
Expert:  The Guy Behind the Tree replied 7 years ago.
If you were charged a penalty, it would appear on the statement that was sent to you for each event of withdrawal. If a penalty wasn't withheld there is still a good chance that one will be assessed by the IRS. I recommend you have your taxes professionally prepared for 2007 because of these complications.

Your car payment is a financial burden, no doubt about it. Can your car be sold for more than you owe on it? If so, that's something to consider. Of course you will still need a car but perhaps one can be found with a reasonable cash outlay or with significantly lower payments. Just a thought.

Can your house be sold in today's economic environment for more than you owe on it? If so, you can use the equity from your house for current cash needs and rent something smaller. Just a thought.

If your house is worth more than you owe on it, can you qualify for a second mortgage? If the payments on the second mortgage are less than the car payments, that would help. Just a thought.

Economic times are difficult now, especially in Colorado. I hope one of these suggestions will work for you.

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