Retired at last. Just when you thought you could kick back and relax, you have to wander through a maze of arcane rules just to get at the money you have so diligently saved in retirement plans. These rules can get mind-bendingly complex. But a close look at the ins and outs of getting your money can make your retirement more lucrative--if not more leisurely.
Lamentably, nothing the Internal Revenue Service does is easy to understand. The rules for withdrawing money from corporate or individual-retirement plans have so many exceptions, twists, and turns that the common wisdom about what to do isn't always dollar-wise. Take the first commandment: Thou shalt not take out money before age 591/2. If you do, you'll usually pay a 10% penalty tax. But if you must tap the money earlier, there are ways--short of death or dismemberment--to avoid a withdrawal penalty. You can take your savings out of a retirement plan in equal annual amounts based on your life expectancy until you turn 591/2. If you're less than five years from that age, you must continue the payout for five years.
So if you're 57 and start taking $5,000 a year, you must continue that schedule until you turn 62. If you start withdrawing $1,000 a year at 45, you must stay at it for 141/2 years, until you turn 591/2. At that point, you can adjust the payouts as you like. There is an exception for company-sponsored plans, which makes it a little easier to crack the safe before 591/2. If you have a 401(k), you can skirt a penalty by leaving your company in the year in which you turn 55--even if you quit to take a job somewhere else. But remember: You'll pay tax on all retirement-plan withdrawals as they're received.
It's crucial to abide by the second commandment of retirement plans: Before age 591/2, thou shalt not have a personal check made out to thee by thy plan custodian. If you do, the custodian of your account--either your company or your bank--will withhold 20% of your savings as taxes. You then have 60 days to cough up that 20% out of your own pocket and roll the entire sum into another plan.
NOTHING PERSONAL. If you don't, you will pay taxes on that money as if you had spent it as well as the 10% penalty. At yearend, you can file for a refund of the 20% that was withheld. To avoid this hassle, make sure the check for any retirement funds you want to move is made out to the rollover trustee, such as a bank or brokerage, for your benefit.
Once you retire, the common wisdom is to avoid touching your IRA or 401(k) until you absolutely have to. But you may be missing an opportunity to get your money out completely tax-free. Often, you can offset income taxes on retirement distributions with exemptions and deductions, says Norman Chiodras, an adviser at Retirement Planners in Oak Brook, Ill. Many older married couples filing jointly can easily rack up some $12,300 in deductions and exemptions a year. Each member of the couple gets a $2,500 personal exemption; together, they get a $6,550 standard married-filing-jointly deduction; plus a $750 deduction if either is over age 65. Apply that to a couple making $27,000 a year, $20,000 of that from Social Security. Since those benefits aren't taxed if a couple's total income is less than $32,000, the only reportable income is $7,000. Subtract that from the $12,300 in deductions, and they will have enough remaining deductions to offset taxes on $5,300 in retirement withdrawals.
In other cases, however, it pays to leave your retirement plan intact. For example, many people think it's better to live off the interest from their savings and preserve the principal. But you can lower your tax bill if you first draw down non-tax-deferred savings. Since you've paid tax on the principal and interest all along, you don't have to report those withdrawals as income. This can protect your Social Security benefits as well, because at lower incomes, Social Security benefits are not taxed.
When you turn 701/2, you must withdraw a minimum sum each year--or suffer a 50% tax on the difference between how much you should have taken and what you actually took. Also beware, counsels Sydney Tucker, an IRA manager for Scudder Stevens & Clark's AARP (American Association of Retired Persons) investment program, that if you transfer your retirement account from one brokerage or bank to another without taking out your minimum distribution for the year, you could be liable for a 50% tax on the distribution. So be sure to take your withdrawal before transferring any of your retirement funds.
TWO FOR ONE. The amount you must withdraw is based on your life expectancy, according to actuarial tables available from the IRS. For example, if the tables say your life expectancy is 16 years, you must withdraw 1/16th, or 6.25%, of the value of your plan the first year. You can reduce this by taking your money as a joint-survivorship annuity with the beneficiary of your plan. That way, your life expectancy is based on both you and your beneficiary and hence will be increased. You can then withdraw smaller amounts over a longer period.
For example, your 16-year life expectancy would grow to 20.6 years with a spouse of the same age, while your withdrawal would drop to 4.85% of the retirement plan's value.
You must decide on a method for determining your life expectancy by the second year after you turn 701/2. You have two choices: the nonrecalculation method or the recalculation method. The former merely reduces your life expectancy by one year each year. The latter lets you refigure your life expectancy each year according to IRS tables. Your life span decreases more slowly with the recalculation method, so your annual withdrawals will be a little less, too.
The vexsome rules continue to hold sway even after you die. If your spouse is your beneficiary, he or she has several options for how to treat the plan's tax status. The spouse can continue deferring withdrawals by rolling the funds into his or her own IRA and delaying distribution until age 701/2. But if the spouse wants the money sooner, he or she can transfer it to a spousal IRA in your name and take distributions on the same schedule as you, the deceased partner, would have.
For example, a couple retires to Tennessee and lives off the husband's IRA. Three years later, the husband dies at age 62. The widow needs the money to live on, but she's only 56. If she rolled the IRA into her own name, she would be liable for the 10% penalty on subsequent distributions until she turns 591/2. By depositing it into a spousal IRA, she can keep the distributions on her husband's schedule.
If the beneficiary is not a spouse, he or she has the choice of taking all of the money after five years, which could be expensive taxwise, or annuitizing it over the recipient's life expectancy. Take an Illinois retiree who at 70 has a $50,000 IRA, which his wife doesn't need to live on. He wills it to his 8-year-old granddaughter. Within a year, she must start withdrawals, but based on her life expectancy of, say, 77 years, her withdrawals will be so small that they will be more than offset by the tax-deferred growth of the balance left in the plan.
Penalties, too, linger after death. Besides estate taxes, a nonspousal heir must pay a 15% excise tax on a retirement account holding more than $150,000. Figuring out what gets taxed is complicated. Ironically, for this purpose, the IRS assigns you a life expectancy after death. "It makes sense if you're on your deathbed to clean out your IRA," says Martin Nissenbaum, a tax accountant at Ernst & Young. "The income tax will reduce your estate and hence the estate tax." On the brighter side, your heirs can deduct a portion of the estate taxes they paid from the income taxes due on the IRA payout.
WHAT TO GIVE. If you're worried about your heirs having to pay taxes, it may help to combine estate planning and charitable giving. So if you have $500,000 in stock and $500,000 in an IRA, give the IRA to the charity of your choice. It pays no tax. Then, says Nissenbaum, transfer the stock to your heirs, who get a step-up in basis to the stock's market value, cutting or eliminating their capital-gains liability. Another option: Put your IRA in a charitable remainder trust. The trust will pay an annuity to the heir until he or she dies, at which point the balance goes to the charity. "Any income generated in the trust gets deferred," says Nissenbaum, "and the heir pays taxes only as he or she gets a distribution."
Unfortunately, this is only the tip of the iceberg. The tax code harbors many more loopholes and traps. Luckily, once you're retired, you'll ideally have plenty of time on your hands to study all of the fine points--between rounds of golf.