EDITOR'S NOTE: This article is from Kiplinger's Success With Your Money special issue. Order your copy today.
When it comes to making crucial decisions about retirement payouts, you don't get do-overs. Instead of checking off boxes and signing forms before rushing off to your retirement party, take time to weigh your options. Making mistakes "can be a very expensive learning curve," says Mark Cortazzo, head of Macro Consulting Group, in Parsippany, N.J. Avoiding them can save you thousands of dollars in taxes.
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MISSTEP #1: Withdrawing money too soon
If you tap your retirement funds before age 59 1/2, you'll owe a 10% early-withdrawal penalty on top of the federal and state income taxes you'll pay on each distribution. There are exceptions that let you withdraw your money early without a penalty -- but only if you follow the rules.
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For example, if you are at least 55 when you leave your job, you can take distributions from your 401(k) without paying a penalty (but you will still owe income taxes on your withdrawals). The key is to keep your money in your employer's plan when you retire. If you transfer it to an IRA, you'll lose the "55-and-out" option.
Jim Conrad of Huntertown, Ind., planned to tap his 401(k) when he retired last fall after 33 years in the auto industry. But there's a catch: Although you qualify for penalty-free access to your money if you are 55 or older, your employer may limit the number of distributions you can take. That's what happened in Conrad's case, forcing him and his wife, Colleen, to come up with Plan B. "We know we'll need to tap some of our savings for income," he says. "We're just trying to figure out the best way."
MISSTEP #2: Interrupting annual payments
So Conrad, 55, is considering another early-out strategy. If he rolls his 401(k) into an IRA, he can make withdrawals penalty-free (but will still owe income taxes) as long as he takes "substantially equal periodic payments" based on his life expectancy for at least five years or until he's 591/2, whichever is longer. There are three ways to calculate these so-called 72(t) payments (named after the section of the tax code that waives the penalty), all of which can be done using the free calculators at www.72t.net.
Let's say you have $500,000 in your IRA when you begin taking distributions at age 56. The IRS life-expectancy table estimates that you will live another 28.7 years. Under the simplest minimum-distribution method, you would have to withdraw $17,422 the first year, then divide your subsequent IRA balances by your declining life expectancy for each of the next four years. The goal is to give yourself early access to some of your retirement savings without wiping out your account. The other two calculation methods would result in payouts of more than $35,000 per year.
If you want to take out less money, you can split your IRA into separate accounts and set up a periodic-payment plan with just one of them. The reverse calculator at www.72t.net lets you plug in the amount you want to receive each year and then tells you how much you need to allocate to the account.
But once you start, you can't change your mind. If you deviate from the payout schedule, you'll owe a 10% penalty retroactive to your first withdrawal, plus interest. Say you took out $75,000 in 72(t) withdrawals over four years, then stopped before reaching the five-year threshold. You would owe more than $8,000 in penalties and interest. Ouch!
MISSTEP #3: Taking a check
If you decide to transfer your 401(k) or other retirement assets to an IRA, make sure they go directly to the new custodian. If your employer cuts you a check, the company will be required to withhold 20% for taxes and you will have to roll the entire amount -- including the 20% you didn't receive -- into an IRA within 60 days. Any money not deposited into the IRA would be treated as a taxable distribution, subject to taxes and early-withdrawal penalties.
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MISSTEP #4: Mishandling company stock
Rolling your 401(k) into an IRA is generally a good idea, but it may not be the right decision when you own company stock inside your plan. That's because distributions from IRAs, 401(k)s and other tax-deferred retirement plans are taxed at your regular income-tax rate, which can be as high as 35%. Sales of investments held longer than one year inside taxable accounts, however, are taxed at a maximum capital-gains rate of just 15%.
To let you take advantage of lower tax rates, there's a special rule for what is called net unrealized appreciation. You're allowed to move your employer's stock out of your 401(k) when you retire or leave your job. But again, you have to follow the rules precisely.
First, you must take a lump-sum distribution of the entire balance in your 401(k). Then you roll all of the money, except the company stock, into an IRA; you deposit the stock into a taxable account. The money in the IRA won't be taxed until you start taking withdrawals. You'll owe income taxes on the stock you transfer. But the tax will be computed based on what you paid for the stock, not its higher, market price.
When Bill Mayer retired from Warner Lambert after 33 years, he had accumulated more than 10,000 shares of company stock, worth more than $700,000, inside his 401(k). But his basis -- what he actually paid for the stock -- was only about $70,000. On Cortazzo's advice, Mayer transferred the stock to a taxable account and paid taxes on his basis at his regular income-tax rate. After that, all subsequent sales of the stock were taxed at the top 15% capital-gains rate. Mayer figures he saved more than $150,000 in taxes, which left him more money to invest.
MISSTEP #5: Ignoring taxes
When it's time to tap your retirement savings, conventional wisdom dictates that you should first withdraw money from your taxable accounts. That allows your IRAs and other tax-deferred accounts to compound for as long as possible. But sometimes it pays to split your retirement withdrawals between your taxable and tax-deferred accounts now to prevent a huge tax bill later.
Retirement is also a good time to review how your investments are allocated among your taxable and tax-deferred accounts. You may be surprised to find that the investment strategies that worked well while you were saving for retirement could work against you when you start withdrawing your money.
There's a big difference between the way investments are taxed inside a retirement account and outside of one. When you hold an asset for more than one year, then sell it at a profit, you pay long-term capital-gains taxes at a maximum rate of 15%—if the asset is held in a taxable account. If that same asset is held in a tax-deferred retirement account, there is no tax consequence when you sell it. But when you withdraw the money from the account, all of it is taxed -- not just your profit -- at your ordinary income-tax rate, which could be as high as 35%. The 20-point spread between the maximum long-term-gains rate and the top ordinary income-tax rate can make a significant difference in your after-tax income during retirement.
But most people have their investments in the wrong accounts when they retire, says Cortazzo. "People tend to hold most of their long-term-growth investments inside their 401(k)s and keep their 'safe money' in CDs and money-market accounts in taxable accounts," he notes. "That's fine while you're accumulating assets, but once you retire you're better off flip-flopping them."
Let's say you have $100,000 invested in stock-index mutual funds inside your 401(k) and another $100,000 worth of certificates of deposit in your taxable account. When you retire and roll your 401(k) into an IRA, you could sell your mutual funds -- with no tax consequence -- and use the money to buy CDs or bonds. You would defer tax payments until you withdraw money from the IRA. At that time, the entire distribution, including the CD and bond interest, would be taxed at your ordinary tax rate -- the same rate you'd pay on the interest from the CDs if they were held inside a taxable account.
But you'd save considerably in your taxable account by cashing in the CDs and buying the same index funds you once held in your 401(k). You'd create a whole new cost basis for the stock funds in your taxable account, and as long as you held the assets for at least a year before selling them, you'd be taxed at the maximum 15% capital-gains rate -- and only on your profits. In addition, you could use any investment losses in your taxable account to offset profits and reduce your overall tax bill -- something you can't do with investments in an IRA.
MISSTEP #6: Waiting too long
You are required to start withdrawing from your IRA by April 1 following the year you turn 70 1/2, and to make withdrawals by December 31 of that year and each year afterward. But if you have a large IRA balance and wait until the deadline, your required distributions could be substantial, pushing you into a higher tax bracket.
John Barber, chief investment officer of TriVant Custom Portfolio Group, in San Diego, urges retirees to take income out of an IRA whenever there will be little or no tax consequences. For example, a retired couple with no income other than IRA distributions could withdraw $17,500 tax-free this year, thanks to a $10,700 standard deduction and personal exemptions of $3,400 each. (If they are 65 or older, they qualify for an extra standard deduction of $1,000 each.) The next $15,650 of income would be taxed at 10%, the lowest federal tax bracket. That means a 65-year-old couple who rely solely on IRA withdrawals could collect about $83,000 in income and still be in the 15% tax bracket in 2007.
Order your copy of Kiplinger's special issue Success With Your Money. It will tell you how to make the most of your money -- and make a seamless transition to the next phase of your life.
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