If you are thinking of retiring soon, you are about to make a major financial decision: how to take distributions from your retirement plan. This Financial Guide will discuss your various options. And, since the tax treatment of these distributions will influence your decision, we will also review the tax rules.
You may have a number of options as to HOW you can take retirement plan distributions, i.e., your share of company or Keogh pension or profit-sharing plans (including thrift and savings plans), 401(k)s, IRAs, and stock bonus plans. Your options depend (1) on what type of plan you are in and (2) whether your employer has limited your choices. Essentially, you can:
Take everything in a lump sum.
Take some kind of annuity.
Roll over the distribution.
Take a partial withdrawal.
Do some combination of the above.
Note: As you will see, the rules on retirement plan distributions are quite complex. They are offered here only for your general understanding. Professional guidance is advised before taking retirement distributions or other major withdrawals from your retirement plan.
Before discussing the specific withdrawal options, let's consider the general tax rules affecting (1) tax-free withdrawals and (2) early withdrawals.
Related Guide: The tax treatment will be dictated not only by the form of the withdrawal (i.e., how to take it) but also by the timing of the withdrawal (i.e., when to take it). This Financial Guide discusses the "how." For a discussion of the "when," please see the Financial Guide RETIREMENT PLAN DISTRIBUTIONS: WHEN to Take Them.
Tax-free withdrawals. If you paid tax on money that went into the plan-that is, if it was made with after-tax funds-that money will come back to you tax-free. Typical examples of after-tax investments are:
Your non-deductible IRA contributions.
Your after-tax contributions to company or Keogh plans (usually, thrift, savings or other profit-sharing plans, but sometimes pension plans).
Your after-tax contributions to 401(k)s (in excess of the pre-tax deferral limit).
Early Withdrawals. Tax-favored retirement plans are meant primarily for retirement. If you withdraw funds before reaching what the law considers a reasonable retirement age-age 59 ½--you usually will face a 10% penalty tax in addition to whatever tax would ordinarily apply.
Example: At age 47, you withdraw $10,000 from your retirement account (and do not roll over the funds). That $10,000 is ordinary income on which you'll owe regular tax at your applicable rate plus a 10% penalty tax ($1,000).
As with any other tax on withdrawal, the 10% penalty doesn't apply to any part of a withdrawal that would be tax-free as a return of after-tax investment
Tip: There are several ways to avoid this penalty tax. The most common are:
You're age 59 ½ or older.
You're retired and are age 55 or older (however, this does not apply to IRAs).
You're withdrawing in roughly equal installments over your life expectancy or your joint-and-survivor life expectancy (discussed later).
The withdrawal is required by a divorce or separation settlement (here, too, this does not apply to IRAs).
The withdrawal is for certain medical expenses.
The withdrawal is for health insurance while unemployed (also available to self-employed).
For IRAs only: The withdrawal is for certain higher education expenses and for first-time home purchases (up to $10,000).
Now let's review the basics for each of the options for taking retirement plan distributions and then discuss the tax planning for each option.
Take Everything in a Lump Sum
You might want to withdraw all retirement funds in a lump sum, perhaps to spend them on a retirement home or assisted living arrangement, on a second home, or to buy or invest in a business. Or you might want to take everything out of a company account because you mistrust leaving funds with a former employer or to take control of investment decisions-though here a rollover (discussed later) might be preferred. Maybe you have to take a lump sum, as some employers will require, though here, too, a rollover option is probably available.
Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans, but may also happen in other plans. Put another way, while plans generally allow lump sum distribution, the employer may have decided to preclude the lump sum form.
Tip: While your funds remain in the plan, earnings on the investment assets grow tax-free. The tax shelter ends once the funds are withdrawn. Preserving this tax shelter is one reason to decide not to withdraw the funds at all or to decide against withdrawing everything in a lump sum. The tax shelter continues, in one form or another, for funds withdrawn as annuities and for funds left in the plan when there's a partial withdrawal of funds. And the shelter continues on rollovers.
Special tax relief applies, in certain cases, for those who withdraw their pension assets in a lump sum. For most, this relief, in the form of "forward averaging," explained below, came to an end on 12/31/99-meaning that withdrawals taken after that date don't get that relief.
Forward averaging reduces your tax below what it would be if figured at regular progressive rates. You will pay tax in one year (for the year you receive it) as if the lump sum amount was received in equal installments over 10 years (for the relief allowed in limited cases after 1999). Forward averaging isn't allowed if any part of the account is or was rolled over to an IRA.
Capital gain treatment for lump sums is available only for those born before 1936 and only with respect to plan participation before 1974. Capital gain may be taken instead of forward averaging and is available after 1999.
It's a "lump sum" if you take out everything left in your account in a single calendar year. If you took $50,000 last year and $250,000 this year, and nothing is left, $250,000 is the lump sum. If you took $250,000 last year and $50,000 this year and nothing is left, $50,000 is the lump sum. In general, lump sum relief is available only once in a worker's lifetime.
The limited lump sum relief remaining is the result of a Congressional plan to phase out the relief, as it has brought down top tax rates and liberalized rollover rules.
Tip: Because lump sum withdrawal ends the tax shelter, it's rarely the road to maximizing wealth. Retirees will usually do better with arrangements that preserve the shelter, through rollovers, annuities or partial withdrawals.
Roll Over The Distribution
Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.
Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan, you might make the rollover as part of a decision to terminate your plan or your business.
Tip: A rollover to your own IRA can give you flexibility in dealing with the funds (for example, so you can invest in options or create a separate IRA for each beneficiary) that would not be available for funds left in your employer's plan. Rollovers can be of the entire retirement account or only part of the account.
Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to expand investment options or to create several IRA accounts. Rollovers also can be made from one pension, profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or set up a new Keogh plan because of starting a new business after you retire.
Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other consequences, some undesirable:
Caution: Federal law grants a person no rights in his or her spouse's IRA. Thus, a plan participant's rollover will strip the participant's spouse of rights the spouse had under the plan from which the assets are being removed. In the case of a pension plan, the spouse has a measure of protection because the spouse must approve the transfer that will forfeit his or her rights. However, no such approval is required in the case of 401(k)s or profit-sharing plans. Thus, a rollover from such plans can eliminate spousal rights. (Employers sometimes provide spousal rights that federal law does not require.)
Caution: A rollover will eliminate the chance of lump sum tax relief, unless the IRA was just a conduit for the movement of funds between retirement plans.
Tip: In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter period. IRA distributions must begin at age 70 ½, but distributions from a retirement plan can be postponed beyond that until the participant retires, unless he or she is an owner of the business.
Tip: A rollover from an IRA to a retirement plan could also get greater creditor protection than if left in an IRA.
Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:
After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to defined contribution plans, but not to defined benefit plans.
You can't roll over amounts you're required to withdraw after reaching age 70 ½ or amounts you're due to receive under a fixed annuity.
Caution: If you do the rollover yourself-personally withdrawing funds from one plan and moving them to another-the plan you're withdrawing from must withhold tax at a 20% rate on the withdrawal. To avoid tax on the 20% withheld, you'll have to come up with that amount from elsewhere and add it to the rollover IRA. (The tax withheld can be taken as a credit against the year's tax liability.) On the other hand, a direct rollover (having the funds transferred directly from the transferring plan to the receiving plan) avoids withholding.
Caution: If you do the rollover yourself, the withdrawn funds are taxable if they don't reach the rollover destination within the deadline (generally, 60 days). Therefore, the least risky way to roll over funds is a direct rollover.
Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or (2) sell it and transfer the cash.
Caution: The rollover is not tax-free if cash is withdrawn, used to buy investment assets, and the new assets are then transferred to the new plan.
Take A Partial Withdrawal
Partial withdrawals are withdrawals that aren't rollovers, annuities or lump sums or don't qualify for lump sum forward averaging or capital gain relief. They include certain withdrawals that you can make while you are still working as well as withdrawals at or after retirement. They may be made for investment or consumption, including education and health care. Because they are partial, the amount not withdrawn continues its tax shelter.
A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum, rollover) of the balance left in the plan.
Note: Before retirement, partial withdrawals are fairly common with profit-sharing plans, 401(k)s, and stock bonus plans. After retirement, they are fairly common in all types of plans (though least common with defined-benefit pension plans)
A partial withdrawal is taxable (and can be subject to the penalty tax on early withdrawal) except to the extent it consists of after-tax funds. The withdrawal is generally tax-free in the proportion the after-tax investment bears to the total retirement account.
Example: Your retirement account totals $100,000, which includes an after-tax investment of $10,000. You withdraw $5,000. The withdrawal is tax-free to the extent of $500 ($10,000/$100,000x$5,000).
Note: The tax-free portion is computed differently for plan participants who were in the plan on 5/5/86.
Do Some Combination Of The Above
Combination withdrawals are quite complex and beyond the scope of this Financial Guide.
For an overview of how states tax retirement plan withdrawals, see State Taxes On Retirement Plan Distributions.
Here are your typical options where whole life insurance is held for you in a retirement plan:
Your employer surrenders the policy to the insurance company for its cash surrender value, which it pays over to you.
Your employer trades in the policy for an annuity on your life.
Your employer distributes the policy to you.
Some mix of the above, such as getting some cash proceeds and an annuity.
The tax shelter ends when cash is received. Otherwise, it continues, to some degree.
Assets Withdrawn In Kind
In general, assets withdrawn in kind (i.e., withdrawn in the form held by the retirement plan, rather than withdrawn in cash) are taxed at their fair market value when received, reduced by after-tax investment. Exceptions:
Stock distributed by a stock bonus plan. Your after-tax investment in the stock comes back tax-free and you pay no tax on the stock's appreciation in value until you sell it. But you have the option to pay tax on the value when received.
Annuity contract. These aren't taxed when distributed. You're taxed under the annuity rules above on annuity payments as received.
Insurance policy. If you convert the policy to an annuity contract within 60 days, the distribution is tax-free. However, you're taxed under the annuity rules as payments are received. If you keep the policy, you're taxed on the policy's cash value (less your after-tax investment).
The Economics Of Retirement Annuities
Retirement annuity economics are built around the straight life annuity, where the retiree receives a certain amount for life, however long or short that might be. This amount stops at the retiree's death. The cost of such an annuity is computed, and that's the cost the employer is obligated to provide.
However, you may want, or be obliged to take, something other than a straight life annuity, such as:
A fixed-term annuity, whereby the annuity will continue for a fixed term (say, ten years) even though you die before the end of this term. (This additional benefit is called a "refund feature.")
A joint and survivor annuity, where the annuity is payable over two lives instead of one.
These types of annuity are worth more than the straight life annuity. But the employer isn't obliged to pay for more than the cost of a straight single life annuity. So if you opt for something other than straight life, the amount you collect each period will be correspondingly reduced to the "actuarial equivalent" of straight life.
Can Creditors Reach Your Retirement Assets
Federal law generally protects your retirement assets or accounts
against claims of your creditors so long as the assets remain in the
retirement plan, except for unpaid federal taxes. Generally, this
protection is in federal labor law (ERISA). Protection denied
under labor law is provided under bankruptcy law (if the case is begun
after October 16, 2005) to:
Keogh plans where the Keogh owner (or owner and spouse) are the
only ones in the plan and
IRA plans, up to the amount rolled over from retirement plans,
plus up to $1 million (which the bankruptcy court may increase where
State Taxes On Retirement Plan Distributions
With 50 different state tax systems, only an overview is possible on how states tax retirement plan withdrawals. Here are the highlights:
A state cannot tax a retirement plan distribution if it imposes no income tax on individuals (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
A state from which a pension is paid, by an employer or former employer in the state, can't tax the pension recipient in another state. In other cases, states generally follow the basic federal approach of taxing retirement distributions as ordinary income (and treating return of after-tax investment as tax-free). But some states don't follow the federal rules for Keogh or IRA investment. Hence, withdrawals from such plans can get state tax relief not allowed under federal law.
Some states grant tax relief for a certain dollar amount of retirement income, relief that extends to retirement plan withdrawals. In some states the relief may look something like the federal credit for the elderly.
Rarely if ever, would a state impose a penalty tax on early withdrawal or on inadequate withdrawals after age 70 ½.