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Taxes on Retirement Income
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Planning ahead can minimize taxes when you start withdrawing
money from your retirement plans.
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If you participate in a
salary reduction plan, such as a
401(k)
or a 403(b),
you must decide how to take retirement income when the time comes. Not only do you
want to minimize the income tax you'll owe, but you also want to avoid the penalties
for withdrawing money before you turn 59½ or, perhaps more important, for taking
too little each year after you turn 72.
There are several ways of handling withdrawals from your account, so you'll
need to figure out how each method works in order to know which suits you best.
Your employer or plan provider should provide some helpful information on your alternatives,
and their tax consequences.
LUMP-SUM WITHDRAWAL Taking all
your retirement money in one lump-sum cash payout can result in a significant tax
bill, especially if you have accumulated enough savings to push you into the highest
tax bracket for the year you withdraw. Future earnings on amounts you reinvest are
also taxed, as are any
long-term capital gains that result from sales of
assets in your portfolio.
But qualified dividend
income and long-term gains are taxed at a rate lower than your regular tax rate.
DIRECT ROLLOVERS You have the
option to roll over your retirement plan assets into an individual retirement annuity
(IRA). The advantages include maintaining the tax-deferred status of your account
while being able to invest the assets in the
separate accounts you choose from among those offered in your contract.
You owe income tax at your regular rate on your withdrawals as you make them.
You can arrange a direct
rollover by having the money transferred to the provider of your IRA.
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INDIRECT ROLLOVERS If you decide
to move your retirement plan assets into an IRA yourself, your employer is required
to withhold 20% of the total you want to move and send that amount to the IRS, as
it does with taxes withheld from your salary. You will receive the amount that's
withheld after you file your next tax return, provided you have deposited the entire
value of your withdrawal including the 20% that was withheld into the IRA within
60 days.
The advantage of this method is that you have the use of your money for the 60 days
between taking it out of your retirement account and the deadline for depositing
it in your IRA. But a serious pitfall is that the amount that's withheld —
the 20% — is considered a taxable distribution if you don't deposit the
full amount within the required period.
Let's say you have $100,000 in a company plan and do an indirect transfer. The
company must withhold $20,000 and gives you $80,000. You must still deposit $100,000
in the IRA within 60 days to avoid taxes and penalties. That means you'll have
to come up with $20,000 from other sources, such as a savings or investment account.
If you deposit only the $80,000, you'll owe income taxes on the $20,000 that
was withheld. If you are younger than 59½, you may also owe a 10% early withdrawal
tax penalty of $2,000. And once you miss the deposit deadline, the tax-deferred
status of the money you don't deposit is gone forever.
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MINIMUM WITHDRAWALS
The law requires
you to begin withdrawing money from your employer-sponsored retirement savings plan
by April 1 of the year following the year in which you turn 72, unless you are
still working. In that case, you may postpone withdrawals until the April following
the year you actually retire. That exception doesn't apply to withdrawals from
traditional IRAs, which must begin when you turn 72, or if you own 5% or more of
the company where you work.
If you don't take the required minimum each year, you owe a penalty of 50% of
the amount you should have withdrawn but didn't. In most cases, your plan administrator
will calculate the amount you must withdraw and pay it to you. If you purchase an
immediate annuity with your plan assets, or
annuitize
your
deferred annuity
, your annual income payments will meet the minimum.
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