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HOW To Take Them
|If you are thinking of
retiring soon, you are about to make a major financial decision: how
to take distributions from your retirement plan. This
Financial Guide will discuss your various options. And, since the
tax treatment of these distributions will influence your decision,
we will also review the tax rules.
TABLE OF CONTENTS
Take Everything in a Lump Sum
Take An Annuity
Roll Over The Distribution
Take A Partial Withdrawal
Do Some Combination Of The Above
You may have a number of options as to HOW you can take
retirement plan distributions, i.e., your share of company or Keogh
pension or profit-sharing plans (including thrift and savings plans),
401(k)s, IRAs, and stock bonus plans. Your options depend (1) on what type
of plan you are in and (2) whether your employer has limited your choices.
Essentially, you can:
- Take everything in a lump sum.
- Take some kind of annuity.
- Roll over the distribution.
- Take a partial withdrawal.
- Do some combination of the above.
you will see, the rules on retirement plan distributions are quite
complex. They are offered here only for your general understanding.
Professional guidance is advised before taking retirement distributions
or other major withdrawals from your retirement plan.
Before discussing the specific withdrawal options, let's consider the
general tax rules affecting (1) tax-free withdrawals and (2) early
||Related FG: The tax treatment will be
dictated not only by the form of the
withdrawal (i.e., how to take it) but also
by the timing of the withdrawal (i.e., when
to take it). This Financial Guide discusses the
"how." For a discussion of the
"when," please see the Financial Guide
DISTRIBUTIONS: WHEN to Take Them.
Tax-free withdrawals. If you paid tax on money that
went into the plan—that is, if it was made with after-tax funds—that
money will come back to you tax-free. Typical examples of after-tax
- Your non-deductible IRA contributions.
- Your after-tax contributions to company or Keogh
plans (usually, thrift, savings or other profit-sharing plans, but
sometimes pension plans).
- Your after-tax contributions to 401(k)s (in excess
of the pre-tax deferral limit).
Early Withdrawals. Tax-favored retirement plans are
meant primarily for retirement. If you withdraw funds before
reaching what the law considers a reasonable retirement age—age 59 ½--you
usually will face a 10% penalty tax in addition to whatever tax would
||Example. At age 47, you withdraw $10,000 from your
retirement account (and do not roll over the funds). That $10,000
is ordinary income on which you’ll owe regular tax at your applicable
rate plus a 10% penalty tax ($1,000).
As with any other tax on withdrawal, the 10% penalty doesn’t apply to
any part of a withdrawal that would be tax-free as a return of after-tax
|TIP: There are several ways to avoid
this penalty tax. The most common are:
- You’re age 59 ½ or older.
- You’re retired and are age 55 or older (however, this does
not apply to IRAs).
- You’re withdrawing in roughly equal installments over your
life expectancy or your joint-and-survivor life expectancy
- You’re disabled.
- The withdrawal is required by a divorce or separation
settlement (here, too, this does not apply to IRAs).
- The withdrawal is for certain medical expenses.
- The withdrawal is for health insurance while unemployed (also
available to self-employed).
- For IRAs only: The withdrawal is for certain higher education
expenses and for first-time home purchases (up to
Now let's review the basics for each of the options for taking
retirement plan distributions and then discuss the tax planning for each
TAKE EVERYTHING IN A LUMP SUM
You might want to withdraw all retirement funds in a lump sum, perhaps
to spend them on a retirement home or assisted living arrangement, on a
second home, or to buy or invest in a business. Or you might want to take
everything out of a company account because you mistrust leaving funds
with a former employer or to take control of investment decisions—though
here a rollover (discussed later) might be preferred. Maybe you have to
take a lump sum, as some employers will require, though here, too, a
rollover option is probably available.
Lump sum is the standard form of retirement distribution for
profit-sharing, 401(k) and stock bonus plans, but may also happen in other
plans. Put another way, while plans generally allow lump sum distribution,
the employer may have decided to preclude the lump sum form.
||TIP: While your funds remain in the
plan, earnings on the investment assets grow tax-free. The tax
shelter ends once the funds are withdrawn. Preserving this tax
shelter is one reason to decide not to withdraw the funds at all or
to decide against withdrawing everything in a lump sum. The tax
shelter continues, in one form or another, for funds withdrawn as
annuities and for funds left in the plan when there’s a partial
withdrawal of funds. And the shelter continues on rollovers.
Special tax relief applies, in certain cases, for those who withdraw
their pension assets in a lump sum. For most, this relief, in the form
of "forward averaging," explained below, came to an end on 12/31/99—meaning
that withdrawals taken after that date don’t get that relief.
Forward averaging reduces your tax below what it would be if figured
at regular progressive rates. You will pay tax in one year (for the year
you receive it) as if the lump sum amount was received in equal installments
over 10 years (for the relief allowed in limited cases after 1999). Forward
averaging isn’t allowed if any part of the account is or was rolled over
to an IRA.
Capital gain treatment for lump sums is available only for those born
before 1936 and only with respect to plan participation before 1974.
Capital gain may be taken instead of forward averaging and is available after 1999.
It’s a "lump sum" if you take out everything left in your
account in a single calendar year. If you took $50,000 last year and
$250,000 this year, and nothing is left, $250,000 is the lump sum. If you
took $250,000 last year and $50,000 this year and nothing is left, $50,000
is the lump sum. In general, lump sum relief is available only once in a
The limited lump sum relief remaining is the result of a Congressional
plan to phase out the relief, as it has brought down top tax rates and
liberalized rollover rules.
||TIP: Because lump sum
withdrawal ends the tax shelter, it’s rarely the road to
maximizing wealth. Retirees will usually do better with arrangements
that preserve the shelter, through rollovers, annuities or partial
TAKE AN ANNUITY
An annuity is the standard form of retirement payout in company and
Keogh pension plans. Annuities are much less common with other retirement
plans, but not unknown. And retirees who receive lump sums (or partial
withdrawals from their accounts) are free to use those funds to buy
Where you have a choice to take funds as an annuity or in some other
form, physical and personality factors may influence your decision.
Persons in failing health tend to choose lump sum distribution while those
with spendthrift tendencies may seek self-protection with annuities.
In retirement settings, the typical annuities are the single life
annuity (starting at retirement and running for the life of the
retiree) and the joint and survivor annuity (starting at the
retiree’s retirement and running for the combined life of the retiree
and another designated person, usually the retiree’s spouse). It can
happen that an annuity starts when the plan participant reaches the
plan’s retirement age, even though the participant continues working
there. This will depend on what the employer’s (including Keogh
owner’s) plan allows. (Plan retirement age is not a factor in IRAs.)
If you’re married and in a pension plan, your distribution
must be in the form of a joint and survivor annuity, unless you and your
spouse both agree in writing on something else—which means that your
spouse is agreeing to forego something he or she is entitled to by federal
law. (Some profit-sharing plans have a similar requirement; this is the
employer’s decision, not a federal rule.) A joint and survivor annuity
must give a spouse who survives your death at least 50% of the amount the
two of you collected during your life. This is called a joint and 50%
survivor annuity. You could arrange for your survivor to get more, up to
100% of what you collect during your life.
in an annuity build tax-free, for future annuity payouts. The shelter
ends, of course, on annuity amounts distributed.
||TIP: A spouse may also forego the right to share in a
joint and survivor annuity arrangement. Here are some reasons for
- Because the couple wants to withdraw a lump sum or make a
large partial withdrawal.
- To name some other person, such as their child or children, as
co-beneficiary in the annuity.
- To take a larger annual amount under a straight single life
You may receive an annuity as a pension from your employer. Or you may
use funds accumulated in a retirement account to buy an annuity. In either
case, the tax treatment is basically the same: The amount you receive
periodically as an annuity is taxed as described below. The amount not yet
distributed to you (but retained in the pension trust or in the insurance
company from which you bought the annuity) is tax-sheltered, with
investment earnings compounding tax-free for future distribution.
Every annuity payment you receive is taxable as ordinary income, unless
you made an after-tax investment, in which case part is taxable and part
tax-exempt. This is the rule whether you're collecting on a single
straight life annuity, a joint and survivor annuity, or any modification,
such as with a ten-year minimum guarantee.
Where you've made an after-tax investment, an IRS table is used to
figure the tax-exempt part. The table is based roughly on the your life
expectancy when the payments begin.
||Example. Your after-tax investment was
$30,000 and you start receiving your monthly annuity at age 62. The
table tells you to divide $30,000 by 260 (months), roughly equal to
your life expectancy at age 62. The result, $115.38, is the tax-free
portion of each monthly payment. In a joint and survivor annuity,
only the owner’s age is used—which slightly increases the
portion treated as tax-free in the early years, thereby slightly
increasing the tax-deferred amount.
Annuity payments received after the end of the period in the IRS table
(after the 260th month in our example) are fully taxable.
ROLL OVER THE DISTRIBUTION
Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.
Rollovers are usually distributions from a company or Keogh plan that
are put into an IRA. You might do this (1) to transfer control of the
funds from your employer to yourself or (2) because your employer forces
the distribution when you leave so as to close its books on your plan
participation. In your own Keogh plan, you might make the rollover as part
of a decision to terminate your plan or your business.
||TIP: A rollover to your own IRA can give you flexibility in dealing with the funds (for example, so you can invest in options or create a separate IRA for each beneficiary) that would not be available for funds left in your employers plan. Rollovers can be of the entire retirement account or only part of the account.
Rollovers can be made from one IRA to another. Apart from Roth IRA
situations, these are usually done to expand investment options or to
create several IRA accounts. Rollovers also can be made from one pension,
profit-sharing or 401(k) plan to another or between types of plan. This
might happen if you change jobs or set up a new Keogh plan because of
starting a new business after you retire.
Rollovers from company or Keogh plans preserve the retirement plan tax
shelter while postponing retirement distributions, thereby often
prolonging the tax-free buildup of retirement funds. They have other
consequences, some undesirable:
||CAUTION: Federal law grants a person no rights in
his or her spouse’s IRA. Thus, a plan participant’s rollover
will strip the participant’s spouse of rights the spouse had under
the plan from which the assets are being removed. In the case of a pension
plan, the spouse has a measure of protection because the
spouse must approve the transfer that will forfeit his or her
rights. However, no such approval is required in the case of 401(k)s
or profit-sharing plans. Thus, a rollover from such plans
can eliminate spousal rights. (Employers sometimes provide spousal
rights that federal law does not require.)
||CAUTION: A rollover will eliminate
the chance of lump sum tax relief, unless the IRA was just a conduit
for the movement of funds between retirement plans.
||TIP: In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter period. IRA distributions must begin at age 70 1/2, but distributions from a retirement plan can be postponed beyond that until the participant retires, unless he or she is an owner of the business.
||TIP: A rollover from an IRA to a retirement plan could also get greater creditor protection than if left in an IRA.
Rollovers are tax-free when properly handled, but consider these
qualifications and exceptions:
- After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to defined contribution plans, but not to defined benefit plans.
- You cant roll over amounts youre required to withdraw after reaching age 70 1/2 or amounts youre due to receive under a fixed annuity.
||CAUTION: If you do the rollover yourself—personally
withdrawing funds from one plan and moving them to
another—the plan you’re withdrawing from must withhold
tax at a 20% rate on the withdrawal. To avoid tax on the 20%
withheld, you’ll have to come up with that amount from elsewhere
and add it to the rollover IRA. (The tax withheld can be taken as a
credit against the year’s tax liability.) On the other hand, a direct
rollover (having the funds transferred directly
from the transferring plan to the receiving plan) avoids
||CAUTION: If you do the rollover yourself, the withdrawn
funds are taxable if they don’t reach the rollover destination within
the deadline (generally, 60 days). Therefore, the least risky way
to roll over funds is a direct rollover.
Where the plan holds specific assets for your account,
a rollover may (1) transfer the specific asset or (2) sell it and transfer
||CAUTION: The rollover is not tax-free
if cash is withdrawn, used to buy investment assets, and the new
assets are then transferred to the new plan.
TAKE A PARTIAL WITHDRAWAL
Partial withdrawals are withdrawals that aren’t rollovers, annuities
or lump sums or don’t qualify for lump sum forward averaging or capital
gain relief. They include certain withdrawals that you can make while you
are still working as well as withdrawals at or after retirement. They may
be made for investment or consumption, including education and health
care. Because they are partial, the amount not withdrawn continues its tax
A partial withdrawal will usually leave open the option for other types
of withdrawal (annuity, lump sum, rollover) of the balance left in the
||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)
A partial withdrawal is taxable (and can be subject to the penalty tax
on early withdrawal) except to the extent it consists of after-tax funds.
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
tax-free portion is computed differently for plan participants who were
in the plan on 5/5/86.
DO SOME COMBINATION OF THE ABOVE
Combination withdrawals are quite complex and beyond the scope of this
|Shows the due dates for filing tax returns,
reporting tax information and taking certain actions to obtain a tax
LIFE INSURANCE OPTIONS
Here are your typical options where whole life insurance is held for
you in a retirement plan:
- Your employer surrenders the policy to the insurance company for its
cash surrender value, which it pays over to you.
- Your employer trades in the policy for an annuity on your life.
- Your employer distributes the policy to you.
- Some mix of the above, such as getting some cash proceeds and an
The tax shelter ends when cash is received. Otherwise, it continues, to
ASSETS WITHDRAWN IN KIND
In general, assets withdrawn in kind (i.e., withdrawn in the form held
by the retirement plan, rather than withdrawn in cash) are taxed at their
fair market value when received, reduced by after-tax investment.
- Stock distributed by a stock bonus plan. Your
after-tax investment in the stock comes back tax-free and you pay no
tax on the stock’s appreciation in value until you sell it. But you
have the option to pay tax on the value when received.
- Annuity contract. These aren’t taxed when
distributed. You’re taxed under the annuity rules above on annuity
payments as received.
- Insurance policy. If you convert the policy to an
annuity contract within 60 days, the distribution is tax-free.
However, you’re taxed under the annuity rules as payments are
received. If you keep the policy, you’re taxed on the policy’s
cash value (less your after-tax investment).
THE ECONOMICS OF RETIREMENT ANNUITIES
Retirement annuity economics are built around the straight life
annuity, where the retiree receives a certain amount for life, however
long or short that might be. This amount stops at the retiree’s death.
The cost of such an annuity is computed, and that’s the cost the
employer is obligated to provide.
However, you may want, or be obliged to take, something other than a
straight life annuity, such as:
- A fixed-term annuity, whereby the annuity will continue for a fixed
term (say, ten years) even though you die before the end of this term.
(This additional benefit is called a "refund feature.")
- A joint and survivor annuity, where the annuity is payable over two
lives instead of one.
These types of annuity are worth more than the straight life annuity.
But the employer isn’t obliged to pay for more than the cost of a
straight single life annuity. So if you opt for something other than
straight life, the amount you collect each period will be correspondingly
reduced to the "actuarial equivalent" of straight life.
CAN CREDITORS REACH YOUR RETIREMENT ASSETS?
Federal law generally protects your retirement assets or accounts
against claims of your creditors so long as the assets remain in the
retirement plan. Here are some exceptions to that protection:
- Unpaid federal taxes
- IRAs (no protection under pension law; limited protection in bankruptacy).
- Keogh plans where the Keogh owner (or owner and spouse) are the only
ones in the plan (no protection under pension law; limited protection in bankruptacy).
||TIP: In addition to federal protection, many
states offer some protection against creditor claims for IRA and
Keogh owners. You might check with your financial or legal advisor
as to whether your state does, and the extent of the protection,
especially before rolling over to an IRA or Keogh.
STATE TAXES ON RETIREMENT PLAN DISTRIBUTIONS
With 50 different state tax systems, only an overview is possible on
how states tax retirement plan withdrawals. Here are the highlights:
- A state cannot tax a retirement plan distribution if it
imposes no income tax on individuals (viz., Alaska, Florida, Nevada,
South Dakota, Texas, Washington, and Wyoming).
- A state from which a pension is paid, by an employer or former
employer in the state, can’t tax the pension recipient in another
state. In other cases, states generally follow the basic federal
approach of taxing retirement distributions as ordinary income (and
treating return of after-tax investment as tax-free). But some states
don’t follow the federal rules for Keogh or IRA investment. Hence,
withdrawals from such plans can get state tax relief not allowed under
- Some states grant tax relief for a certain dollar amount of
retirement income, relief which extends to retirement plan
withdrawals. In some states the relief may look something like the
federal credit for the elderly.
- Rarely if ever, would a state impose a penalty tax on early withdrawal or on inadequate withdrawals after age 70 1/2.