Rollovers and Distribution Planning

Retirement (1)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.

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.

Note: As 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 withdrawals.

FYI: 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 Guide discusses the “how.” For a discussion of the “when,” please consult with a Tampa Bay Financial Group member.

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 investments are:

  • 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 ordinarily apply.

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 investment

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 (discussed later).
  • 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 $10,000).

Now let’s review the basics for each of the options for taking retirement plan distributions and then discuss the tax planning for each option.

The Basics
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.

Tax Planning
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 worker’s lifetime.

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 withdrawals.

The Basics – The Fixed Indexed Annuity
Retirees who receive lump sums (or partial withdrawals from their accounts) are free to use those funds to buy annuities like fixed indexed annuities, that protect all premiums paid and earned interest from market loss.

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.

MORE: To help you decide on the type of distribution to choose, see The Economics of Retirement Annuities.
Note: Funds 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 doing so:
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 annuity.

Tax Planning
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.

The Basics
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 employer’s 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.
CAUTION: A rollover will eliminate federal protection against creditor claims, refer to the special section: Can Creditors Reach Your Retirement Assets?
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.

Tax Planning
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 can’t roll over amounts you’re required to withdraw after reaching age 70 1/2 or amounts you’re 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 withholding.

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 the cash.

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.

The Basics
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 shelter.

A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum, rollover) of the balance left in the plan.

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)

Tax Planning

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 ($10,000/$100,000x$5,000).
Note: The tax-free portion is computed differently for plan participants who were in the plan on 5/5/86.

Combination withdrawals are quite complex and beyond the scope of this Financial Guide.

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