Taking Distributions from Tax-Deferred Retirement Savings Plans Putting money into an employer s retirement plan is just the first step toward financial security in retirement. How you withdraw the money also requires careful decision making. If you are enrolled in an employer s retirement savings plan, such as a 401(k), 403(b), or a defined benefit pension plan, or if you have an IRA, SEP or Keogh, you or your heirs must decide how to withdraw those funds. The rules that apply and the choices you have will vary with the type of plan, the reason for the distribution, and your age. This fact sheet introduces the choices and considerations involved in taking distributions from tax deferred savings vehicles. It describes legal requirements that employees and employers must meet. Individual plans may also have other rules or options. Laws change, and individual employer s plans may have slightly different choices, so view this as only a guide. Age at Time of Distribution How distributions are taxed depends largely on your age at the time of the withdrawal, as shown in Table 1. Some tax penalties encourage you to leave your retirement savings untouched until you approach retirement age. Other penalties insure that you make regular withdrawals in retirement so that you don t defer taxes indefinitely. There are several exemptions to the 10% early distribution penalty, but the specifics vary according to the type of plan. Table 2 summarizes the major exceptions. Hardship withdrawals are not an exception. Profitsharing or 401(k) plans may allow hardship withdrawals, but the amount you withdraw would be subject to the 10% early distribution penalty. State County Local Groups United States Department of Agriculture Cooperating University of Illinois Extension provides equal opportunity in programs and employment.
2 Taking Distributions Table 1: Tax Treatment of Distributions by Age Category Age Federal Income Tax Treatment of Distributions To avoid penalties* Under 59½ Taxed at your marginal rate plus a 10% early distribution penalty; SIMPLE plans carry a 25% penalty on withdrawals made during first two years of participation. Rollover to an IRA or another employer plan, or meet one of several exceptions (see Table 2); in the first two years of participation in a SIMPLE plan, rollover to a regular IRA is not allowed. 59½ to 70½ Taxed at your marginal rate; no penalties apply except for some 457 plans* 70½ and over Taxed at your marginal rate plus a 50% penalty on any minimum distribution amount not taken; annual minimum distribution is based on life expectancy tables Withdraw required annual minimum distribution each year; first distribution by April 1 of year following year in which you reach age 70½; second distribution by Dec. 31 of that same year. If you work past age 70½, there may be exceptions. * Penalties do not apply to distributions from government Section 457 Deferred Compensation plans. Other 457 plans are subject to the early distribution penalty unless the participant has separated from service or qualifies for an emergency withdrawal.
Taking Distributions 3 Table 2: Distributions Exempt from the 10% Early Distribution Penalty Reason for Distribution Type of Retirement Plan Traditional IRA/SEP IRA/SIMPLE IRA* 403(b) or Tax-Sheltered Annuity Qualified Plan Participant s death Yes Yes Yes Participant s disability Yes Yes Yes Participant s separation from service after age 55 No Yes Yes Distributions part of a series of substantially equal periodic payments lasting at least 5 years or until age 59½, whichever is later Yes Yes only following separation from service Yes only following separation from service Distribution to cover medical expenses exceeding 7.5% of adjusted gross income Yes and for medical insurance premiums after receiving unemployment for 12 consecutive weeks Yes Yes Payment to alternate payee under a Qualified Domestic Relations Order (QDRO) Down payment on first home (up to $10,000) or qualified higher education expenses No Yes Yes Yes** No No *Roth (back-loaded) IRAs are not tax-deferred investments, and different rules determine whether distributions are tax-free. Distribution of the earnings on contributions to a Roth IRA must occur at least five years after January of the year the first contribution was made, and the distribution must also be made either after age 59½, due to death or disability, or for a down payment for a first-time home buyer. **First-time homebuyer and higher education expense exemptions from the 10% early distribution penalty these exemptions apply to SEP and SIMPLE IRAs.
4 Taking Distributions Types of Distributions Lump-Sum Distributions You may be able to take the value of your retirement plan in a lump sum when you change jobs or when you retire. You can typically roll over lump sums or partial distributions if the distribution is not part of a required minimum distribution or a series of equal distributions (72t rule) used to avoid early distribution penalties. You can roll a distribution over into a traditional IRA or another qualified plan and continue to defer taxes. Distributions from 403(b) and 457 plans can be rolled over to a traditional IRA, 403(b), 401k or 457 plans. How you set up the rollover has important consequences: Direct rollover: If you have the money transferred directly to a traditional IRA or your new retirement plan, there is no withholding and the tax-deferred status is preserved. Indirect rollover: If you receive the funds yourself, 20% of the distribution will be withheld for income taxes. You have 60 days to roll the money over to a traditional IRA or an employer plan to avoid taxes and penalties. If you roll over only the 80% that you actually received, you will be taxed and perhaps assessed a penalty on the 20% that was withheld for taxes. To avoid all taxes and penalties, you must deposit the full amount of your old plan into your new account. You will have to replace the 20% that was withheld with other money, and wait until you file your income tax to seek a refund of the amount withheld. Forward averaging is a way to calculate income tax on a lump-sum distribution as if it had been received over a period of years. Individuals born before 1936 may elect 10-year forward averaging for lump-sum distributions. However, you still must pay the tax all at once. The employee and the distribution must meet strict requirements to qualify. The five-year averaging option has not been available since 1999. The risk that you face when you take your money as a lump sum is that you will outlive your money. You will also probably pay more tax even with forward averaging than if you take annual distributions, and you will lose additional years of tax deferral. Planning Tips Choose direct rollovers (transfers) rather than indirect rollovers to avoid the 20% withholding and the risk of missing the 60- day rollover period. Don t risk losing the money s tax-deferred status and having to pay taxes on the full amount. Once you roll over money from an employer plan into an IRA, the funds are under IRA rules for distributions. If you took a loan from your retirement plan and you take a lump-sum distribution (even a rollover), the amount of the loan that has not been repaid will be taxed as income and may carry early withdrawal penalties. Other things being equal, deferring taxes as long as possible is the best financial decision. Delaying your distributions from tax-deferred savings will let them continue to grow faster than if you withdrew the money. (After you pay taxes, there is less to grow from.) However, the reduction of capital gains on investments outside of retirement plans that started in 1997 makes this choice less clear, especially for those closer to retirement.
Taking Distributions 5 Annual Distributions Retirement plans often offer annual distributions as an alternative to taking a lump sum when you retire. Some people who are under age 59½ choose regular, annual distributions as a way to access their money and avoid the early distribution penalty. Once you reach age 70½, you will be required to take minimum annual distributions from the Uniform Withdrawal Factor Table provided by the IRS. Each year, you will divide the amount in your account at the end of the previous year by the MRD Withdrawal Factor associated with the IRA Owner s Age listed on the IRS table to determine the minimum distribution. You can always withdraw more than the minimum amount, but you will pay a stiff penalty if you withdraw less. If you work past age 70½, you may delay distributions from your current employer s plans until you retire. This does not apply to plans of previous employers or IRAs. Also, owners of more than 5% of a company are not allowed to delay their minimum distributions past age 70½. Unfortunately, qualified plan owners cannot use the new tables unless their company plan is amended. In other words, if you are a retired employee and your money is still in the company plan, if the company does not amend their plan, then you can't use the new tables. The excess-withdrawal penalty has been repealed, so there is no additional tax imposed on large annual or lump-sum distributions. Planning Tips Remember, a minimum distribution is just that, you can always withdraw more. Balances in your IRAs are added together to determine your minimum withdrawal, but you can take it all from one IRA or withdraw from several. You will also have to take minimum distributions from defined-contribution retirement plans such as profit sharing and 401(k) plans, and 403(b) plans. Consider your health, life expectancy (given your family history, health, etc.) and anticipated needs to decide whether to choose annual distributions, a lump sum, or an annuity. More people are setting retirement goals that assume they will live to age 95 or older as the percentage of people living past 95 is increasing dramatically. If you are working past age 70½ and want to delay taking distributions from your current employer s plan, check with your employer to make sure that the plan s rules have been amended to allow the delay. Annuitized Payments Rather than taking your money in a lump sum or in annual payments that will end when your investment is exhausted, you may choose an annuity that guarantees you payments for your lifetime, the joint lifetime of you and a beneficiary, or for your lifetime with a guaranteed number of payments even if you die first. This is referred to as annuitizing. Annuitized payments are the automatic method of payment for defined benefit plans, unless you specifically make a different choice. Other retirement plans may also offer an annuity as a payment option. Defined benefit plans, some defined contribution plans, and 403(b) plans must offer annuities that provide survivorship benefits to spouses of plan participants. When the participant retires, the employer must offer a qualified joint and survivor annuity that will pay the spouse a specified percent of the participant s annuity if the spouse survives the participant. The plan must also offer a qualified
6 Taking Distributions pre-retirement survivor annuity that will pay benefits to the spouse if the participant dies before retirement. The main advantage of an annuity is that you won t outlive your money (except for period certain annuities). However, annuities carry their own set of risks. You may die early and get very little of your investment back. Your spouse could die first, even after you have chosen a joint and survivor annuity with its smaller monthly payments. Also, inflation will reduce the value of your annual payments over time. Do not confuse this method of taking your distributions with the investment product that is called an annuity. Annuities allow you to invest money for either fixed or variable returns and defer tax on the those returns. You may buy an annuity directly from an insurance company. An annuity may also be one of your investment choices within your employer s retirement plan. Distributions from annuities do not necessarily have to be annuitized; lump-sum distributions or other choices may also be available. Taxation of annuities: Under retirement plan annuities, the full amount will be taxable upon distribution if you bought the annuity with pretax dollars. For annuities bought outside a retirement plan, a formula determines the portion of each annuity payment that is taxable, based on your investment in the annuity. Planning Tips Know your rights to your spouse s retirement savings (and his/her rights to yours), so that you won t waive this important property right unless you ve given it serious consideration. Beware of the effect of inflation on your annuity payments. If your payment does not increase with inflation, an income that seems generous in the beginning will erode with inflation. Think twice before choosing an annuity as your investment within an employer s plan. Taxes on both your contributions and investment returns are deferred until you withdraw the money. Buying an annuity as the investment within a tax-deferred plan offers no additional benefit and will have additional costs compared to other investment choices. Factors that Affect the Amount of Your Distribution Integration with Social Security: Some qualified plans may subtract some of your Social Security benefits when calculating your plan benefit. That results in higher pension benefits for highly-paid employees whose earning were more than the maximum subject to Social Security tax. It means smaller benefits for those who earned lower salaries and who will get a higher proportion of their salary from Social Security. Read your retirement plan s summary description to see how it treats Social Security benefits. Social Security offset: If you worked in a government position where your earnings were not subject to Social Security, the pension you get from that job may reduce the amount of Social Security you can receive either on your own work record or from your spouse s work. For details, get Government Pension Offset and A Pension From Work Not Covered by Social Security from the Social Security Administration.
Taking Distributions 7 Distributions at Death How the balance of your retirement accounts is distributed after your death depends on your beneficiary, whether you had begun to take distributions from the plan before your death, and whether you annuitize. For IRAs, it also depends on the specific rules of the individual plan. Naming a beneficiary. The new tax law permits the beneficiary to be determined as late as the end of the year following the year of the your death. This permits: you to change designated beneficiaries after the required beginning date without increasing the required minimum distribution the beneficiary to be changed after your death, such as by one or more beneficiaries disclaiming or being cashed out the calculation of post-death minimum distributions to take into account your remaining life expectancy at the time of your death, thus allowing distributions in all cases to be spread over a number of years after your death. Your beneficiary spouse survives you. At your death the spouse has the option of rolling over the plan balance to his/her own account and using his/her own age and life expectancy to determine required distributions. If your spouse does not roll over the account, the required distributions depend on whether you had begun taking distributions. If you had not begun taking distributions, your spouse must (1) begin taking distributions by December 31 of the year following the year you died, (2) by December 31 of the year in which you would have reached age 70½, whichever is later or (3) within 5 years from your death. If you had begun taking distributions, your spouse must take distributions at least as fast as the schedule in effect when you died. The beneficiary is not your spouse. If you died before you had started taking distributions, the entire account must be distributed within five years of your death or over the life expectancy of the beneficiary, with distributions beginning by December 31 of the year following death. If you died after you had started to take distributions, the beneficiary must take distributions at least as fast as the schedule in effect when you died. You died while receiving annuitized payments from a retirement plan. If you chose a single life annuity (your spouse must have signed a written waiver of rights to a survivor s annuity), no further benefits are payable at your death. If you chose an annuity with period certain and die before the period certain has ended, payments will be made for the remaining guaranteed time period to your spouse or other beneficiary. If you chose a joint annuity and you died first, the survivor will receive the selected amount until his/her death. Typically, the spouse s payment is 50%, 66.66% or 100%
8 Taking Distributions or some other percentage of the payment received during the owner s lifetime. Taxes on Distributions at Death Income taxes: Your estate or beneficiary will owe income taxes on any benefits for which you would have owed income taxes. The funds will be taxed when they are distributed. Estate taxes: Unless the total of your individual estate including your retirement plans and any taxable gifts you have made in your lifetime is more than the exclusion allowance equivalent, you will owe no federal estate tax. The exclusion allowance equivalent is $1,000,000 in 2002 and 2003 and will reach $3,500,000 in 2009 with possible estate tax repeal in 2010. The excess accumulation penalty on undistributed retirement savings plans has been repealed. Suggestions for Making Decisions About Your Distributions Know the laws so you can avoid any penalties and unnecessary taxes. Plan ahead so you won t be forced to make a quick decision that you may not have thought through. Individual employer s plans may have additional or outdated rules. Check your employer s plan to see what options you will have. Must you withdraw funds in a lump sum if you leave the employer before retirement age? Must you leave funds with your employer? What payment options are offered at retirement? Consult a professional if you need help in making the wisest choice. Don t be alarmed by warnings that your heirs will receive only a small percentage of your retirement savings unless all the assumptions apply to you. These warnings assume that your retirement accounts will be hit by estate taxes, generation-skipping transfer taxes, and income taxes all at once. Estate tax applies only if your estate is over the exclusion allowance equivalent. The generation-skipping transfer tax only affects your estate if you transfer more then $1,060,000, as indexed, to heirs two or more generations removed from you. Therefore, income tax may be your only concern. Distribution planning is very technical. Err on the side of caution and check with your tax advisor if you have any questions.
Taking Distributions 9 References Bock, C. A. and Harris, P. E. (1997). 1997 Farm income tax school workbook. Urbana: University of Illinois. CCH (1997). 1997 Tax legislation series: Law, explanation, and analysis. Chicago: CCH Incorporated. Hallam, E. (1997). Pension law changes: what you need to know. Presentation at the College for Financial Planning 1997 National Conference, Denver, CO. Holt, M. C. (1997). Estate planning for qualified plans and IRAs. Presentation at the College for Financial Planning 1997 National Conference, Denver, CO. Internal Revenue Service. (1997). Special Report: President signs balanced budget legislation www.irs.ustreas.gov/plain/hot/tax-law.htm>, September 10, 1997. Leimberg, S. R. and McFadden, J. J. (1995). The tools & techniques of employee benefit and retirement planning (4th ed.). Cincinnati: The National Underwriter Company. Written by: Karen Chan, CFP, and Charlotte F. Crawford, CFP, Extension Educators, Consumer and Family Economics, University of Illinois Extension. Reviewed by: Katie Arendt, CFP, Chicago, IL; Patricia Brennan, CFP, Family and Consumer Sciences Educator, Rutgers Cooperative Extension; Cheryl L. Kampen, J.D., Denver, CO; Jan Lukens, MBA, CFP, Associate Consumer Management Specialist, Mississippi State University, Extension Edited by : Brenda Cude, PhD., State Specialist, Family and Consumer Economics, University of Illinois Extension. Copyright 2002 by the Board of Trustees of the University of Illinois. February, 1998 Updated August, 2000 and December 2001