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Overview
 When you take money out of a traditional IRA, much-if
not all-of it is taxable. As you consider a withdrawal
around year-end, weigh the potential advantage of holding
off until the new year arrives. If you can wait to put
your hands on the money, you can make Uncle Sam wait
an extra year before he gets his share. But if you'll
find yourself in a higher tax bracket in the future-due
to higher income or increases in the tax rates-you may
want to speed up IRA withdrawals to avoid the stiffer
tax bite.
In the year you reach age 70 1/2, the law demands that
you begin withdrawals from your traditional IRA. But
the first mandatory distribution-the one for the year
you turn 70 1/2-can be put off until as late as the following
April 1. Holding off trims your taxable income and your
tax bill in the current year. But you must double up
in the second year. In addition to the withdrawal made
by April 1, another has to be made by December 31. If
the resulting boost in taxable income shoves you into
a higher tax bracket, your income-deferral strategy could
backfire. (Note: You do not have to begin withdrawals
from a Roth IRA at age 70 1/2 or at any other age. Since
payouts are not taxable, the IRS doesn't care when you
start. Mandatory withdrawals are required from a Roth
you inherit, though.)
Moving
Your IRA Money Around
Although a key trade-off for the IRA tax breaks is the
threat of the 10% early-withdrawal penalty, you are not
locked into the same investment from the time you put
your money in the tax shelter until you retire. You may
move your money around freely to take advantage of changes
in market conditions or your investment philosophy.
401(k)
Plans
There
is a limit on how much you can sock away in a 401(k)
each year, but the limit is far above the IRA cap.
For 2002 the cap was $11,000 and it will continue to
increase in $1,000 increments until it hits $15,000
in 2006. Starting in 2002, workers age 50 and older the
end of the year will be allowed to make "catch up"
contributions above and beyond the set dollar limitations.
For 2002, the catch up amount was $1,000, setting a $12,000
contribution ceiling for a worker age 50 and older. The
catch up amount will also rise in $1,000 increments until
it hits $5,000 in 2006. For 2003, the general limit is
$12,000, and the catch-up amount is $2,000. Clearly,
Congress wants to encourage us to save for our retirements.
Your personal limit depends on your salary and what percentage
the company permits you to put into the retirement plan.
Most firms allow contributions of between 2% and 15%
of compensation.
A special attraction of 401(k) plans is that most firms
offering them sweeten the pot by matching part of the
employee's contribution. Matching contributions do not
count toward the annual contribution cap. If you quit
after just a few years you may forfeit part or all of
the matching deposits.
A 401(k) counts as a company retirement plan for purposes
of the squeezing your right to deduct regular IRA contributions,
but steering part of your salary into a 401(k) may boost
the size of your allowable IRA deduction. Because 401(k)
contributions reduce your taxable salary, they may pull
your AGI down to a level that permits IRA deductions.
Getting
Your Money Out
Basically, salary funneled to a 401(k) account is usually
locked up until you leave the company, unless you die
or become disabled first.
You may be able to get at your money early if you face
financial hardship, though you have to be in pretty bad
shape to qualify. Basically, you must prove an immediate
and heavy financial need-to pay medical bills, cover
a down payment on a home or avoid being evicted, for
example-to qualify for a hardship withdrawal. You also
have to show that you don't have another source for the
cash-that your savings are depleted and you're unable
to borrow from a bank. The IRS imposes other restrictions,
too, and it's up to your company to decide whether or
not to permit hardship withdrawals and, if so, under
what circumstances.
Even if your plan provides for such withdrawals, you're
not home free. Hardship withdrawals made before age 59
1/2 are subject to a 10% early-distribution penalty.
The money will also be taxed in your top bracket. The
most you can pull out for hardship expenses is the total
of your personal contributions to the account. You are
not allowed to touch company deposits or earnings.
You can get your
money when you leave the job, but if that's before
the year you reach age 55, you have to worry about
the 10% early withdrawal penalty. Note, however, that
the penalty is waived for the following reasons:
- After your death
- Because of
your disability
- As part of a series of roughly
equal payments based on your life expectancy or the
joint life expectancy of you and a beneficiary
- To pay deductible medical
expenses that exceed of 7.5% of your adjusted gross
income.
At any age, you can avoid the penalty on a 401(k) payout
by rolling the funds into an IRA.
If you were born before 1936 and receive a lump-sum
distribution from your 401(k) when you leave the company,
it might qualify for the 10-year forward averaging method
to trim the tax due.
401(k)
Loans
There may be a way to tap your account early without
being burned by the 10% penalty. Company plans can permit
employees to borrow from their accounts. Basically, you
can borrow no more than half of your account, up to a
maximum loan of $50,000, and the loan must be repaid
within five years, unless the money is used to buy a
principal residence. If you use the money to buy a house,
you can take longer to pay it back. Although the law
permits such loan provisions, it's up to your company
whether you can borrow from the plan.
Company
Pension and Profit-Sharing Plans
The same 10% penalty that hits early withdrawals from
individual retirement accounts applies if you receive
money from a company plan early. Although early is
defined in the law as before you reach age 59 1/2, an
exception to the penalty means most employees can take
penalty-free payouts starting the year they reach age
55. The age 55 exception applies if you get the payout
because you leave the job-which, of course, is usually
the case. The penalty stretches to age 59 1/2 only for
withdrawals while you're still on the job. (Note that
the exception applies in the year you reach age 55; you
don't have to be 55 when you leave the job and get the
money as long as that birthday comes by December 31.)
Since the point of retirement plans is to help make
sure you'll have money to live on in retirement, the
10% penalty is designed to encourage you to roll over
early payouts into an IRA. Such a rollover lets you dodge
the 10% penalty but, once inside the IRA, the money is
still tied up until you're at least 59 1/2.
As with 401(k) plans, there are other exceptions to
the early-withdrawal penalty. At any age, it does not
apply if:
- You are disabled
- The distribution is made to your beneficiary after
your death.
- The payments are made in roughly equal installments
over your life expectancy or the life expectancy
of you and your beneficiary.
- The money is used to pay medical expenses in excess
of 7.5% of your adjusted gross income.
Retirement
Income
If you receive regular payments from a company pension
or annuity, tax may or may not be withheld. The same
goes for withdrawals you take from a regular IRA. Believe
it or not, it's up to you whether part of the money will
be skimmed off for the IRS.
If you want to forbid Uncle Sam from dipping into your
retirement checks, all you have to do is file a form
with the payer. The company that pays your pension or
annuity should periodically remind you of your option
to block withholding and tell you how to do it.
Note, though, that withholding on these payments isn't
necessarily a bad thing, since it stretches the tax bill
over the entire year rather than leaving the bill to
be paid all at once at tax time. Withholding might make
life easier if the alternative is to make quarterly estimated
tax payments, which are discussed later. If you allow
it, the amount held back from pension and annuity checks
is based on information you provide on a form W-4P, just
as withholding on wages is controlled by a W-4.
You
don't have to retire to be affected by these rules.
If you roll over funds from one IRA account to another,
10% will be withheld unless you order the company that
makes the payment not to withhold.
Pension
Payout Trap
Don't get tripped up by the withholding rule that can
sting employees who get lump-sum payments from company
retirement plans-the kind of payment you might receive
not only when you retire, but also if you quit or are
laid off.
Not so long
ago, withholding on such payments was voluntary. The
best course for most taxpayers, in fact, was to say "no''
to withholding, take the money and roll it over into
an individual retirement account (IRA). Doing so within
60 days meant no tax was due on the payout, so there
was no need for withholding.
Now, however, if you take the money, 20% of it is automatically
withheld for the IRS. That's true even though a rollover
will still allow you to avoid the tax. In that case,
the IRS would have the money you don't owe until you
file a tax return for the year and demand a refund.
Congress set the 20% withholding trap to raise money-an
estimated $2 billion over five years. But only unsuspecting
taxpayers will pay it because there's an easy way around
withholding: Simply ask your employer to send the money
directly to your rollover IRA. As long as the money doesn't
pass through your hands, there is no withholding.
Even if you intend
to spend some of the money right away, your best bet
is still probably to ask your employer to make the direct
IRA transfer. Then, when you withdraw funds from the
IRA, it's up to you whether there will be withholding.
For more information on the advantages and potential
problems concerning lump sum distributions.
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