Planning Retirement Withdrawals

If you are thinking of retiring soon, or changing jobs, you may face a major financial decision: what to do about the funds in your retirement plan. This article will discuss partial withdrawals and full withdrawals.

Note: As you will see, the rules on retirement withdrawals are quite complex. They are offered here only for your general understanding. Please call us before taking withdrawals or making other major changes in your retirement plan.

Take a Partial Withdrawal

Partial withdrawals are withdrawals that aren’t the rollovers, annuities or lump sums. Because they are partial, the amount not withdrawn continues its tax shelter, see below.

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).

Tax Planning. A partial withdrawal is taxable (and can be subject to the penalty tax on withdrawals before age 59 ½ ) except to the extent it consists of after-tax contributions, such as nondeductible IRA contributions. 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 / $100,000 x $5,000).

Note: The tax-free portion is computed differently for plan participants who were in the plan on 5/5/86.

Preserving the Tax Shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution—or the smaller the amount you must withdraw—the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows to maximize assets and shelter them for the next generation.

The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter which was intended to aid your retirement.

Withdrawal Before You Reach Age 70½

Until the year you reach 70½, you need not take your money out of your retirement account—unless your employer’s plan requires this. In fact, there will usually be a 10% early-withdrawal penalty if you make withdrawals before age 59½. This is on top of the regular income tax you will owe at any age on amounts withdrawn, though there’s no tax on your recovery of after-tax contributions you made.

Once You Reach Age 70½

Once you hit 70½, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 70½—say April 1, 2008 if you reach 70½ in 2007. But waiting until April 1 means you must withdraw for two years—2007 and 2008—in 2008. To avoid this income bunching and a possible higher marginal tax rate, your tax adviser may suggest withdrawing in the year you reach 70½.

The rules allow you to spread your withdrawals over a period substantially longer than your life expectancy. Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the future period (at that age) over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the minimum amount to be withdrawn for the year.

Example: Joe reaches age 70 1/2 in October of this year. Retirement plan assets in his IRA totaled $600,000 at the end of last year. The IRS number for age 70 is 27.4. Joe must withdraw $21,898 ($600,000/27.4) this year.

Example: Two years from now Joe is 72 and his IRA was $602,000 at the end of the preceding year (when Joe reached age 71). The IRS number for age 72 is 25.6. Joe must withdraw $23,516 ($602,000/25.6) when he’s 72.

The distribution period in the IRS table in effect assumes distribution over a period based on your life expectancy plus that of a beneficiary 10 years younger than you. Only where your designated beneficiary is a spouse more than 10 years younger than you is his or her actual life expectancy used to figure the withdrawal period during your lifetime.

Caution: You can always take out money faster than required–and pay tax on these withdrawals. However, the tax code is strict about minimum withdrawals. If you fail to take out what’s required, a tax penalty will take 50% of what should have been withdrawn but wasn’t.

Financial Calculator: Required Minimum Distribution
The IRS requires that you withdraw at least a minimum amount - known as a Required Minimum Distribution - from your retirement accounts annually, starting the year you turn age 70-1/2. Determining how much you are required to withdraw is an important issue in retirement planning.

This entry was posted on August 17, 2008 at 5:40 pm and is filed under What's New. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.

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