Planning ahead can minimize taxes when you start withdrawing money from your retirement plans.
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 70½.
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.
SOCIAL SECURITY BENEFITS Depending on how high your total income is when you draw Social Security benefits, you may be taxed on 50% or as much as 85% of your Social Security income. You may also be penalized if you go on working after you start receiving benefits. In 2019, if you're between 62 and 66 you'll lose $1 of benefits for every $2 you earn above $17,640. The year you reach full retirement age, you lose $1 for every $3 you earn over $46,920 in the months prior to reaching that age. But after reaching full retirement age, you don't lose any benefits when you work.
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.
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.
ROTH 401(k) PLAN Some employers offer the Roth 401(k) retirement plan, which allows you to make contributions with after-tax dollars that can grow tax-free. The big difference between a traditional 401(k) and a Roth 401(k) is that you won't pay taxes on money you withdraw, as long as your account has been held for at least five years and you are at least 59½. You will need to begin taking minimum distributions by the time you reach age 70½, but after you leave your job you can convert Roth 401(k) assets to a Roth IRA, which has no required withdrawals. This feature for the Roth offers a way around the distribution requirements if you're planning to leave the account to an heir or if you simply don't want to withdraw money by age 70½.
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.
EARLY WITHDRAWALS ARE SOMETIMES OKAY You generally must pay a 10% tax penalty for withdrawing money from an employer's retirement savings plan before you turn 59½ if you don't roll it over into another tax-deferred plan. But there are several exceptions:
You may take money at any age as an annuity, which means you'll receive approximately equal annual payments for at least five years or until you turn 59½, whichever is longer
You may make withdrawals at any age if you're totally and permanently disabled
You may withdraw money from your plan if you retire at age of 55 or later
You may withdraw at any age if you use the money for deductible medical expenses
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 70½, 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 70½, 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.