Financial Q&A: Tactics to Avoid Double Taxation on Retirement Funds

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Q: How can I avoid paying taxes on withdrawals from my 401(k) twice? I withdrew from my 401(k) and put that money into an IRA. Consequently, I have to pay taxes twice on that money. It's not fair!

F.E., via e-mail

A: For all practical purposes, says Jon Clark, a certified financial planner in Anderson, Ind., you won't have to pay taxes twice on the 401(k) money. You may have to pay taxes on future earnings, however, depending if you funded a traditional IRA or a Roth IRA.

When there is a desire to fund an IRA or Roth IRA, it is not a good idea to take that money from a qualified plan such as a 401(k) or 403(b), he says. If you were younger than 59-1/2 when you withdrew funds, you would have been hit with a 10 percent early withdrawal tax penalty, and the 401(k) should have withheld 20 percent for taxes.

The only way to avoid paying taxes on the withdrawal would have been to take the proceeds, pay from your own pocket the 20 percent that was pulled out for taxes, and fund the IRA within a 60-day period. Assuming you paid all your taxes in the current year, the 20 percent originally withheld will be refunded when you file.

But funding an IRA this way can be a confusing task. A direct rollover to an IRA would have been a much better option, says Mr. Clark, as there would be no taxes due at this time, money would not have been withheld for taxes, and there wouldn't have been an early withdrawal penalty.

As it is, since you have already paid taxes, you could fund a Roth IRA if you have other taxable compensation for the year. …