Key Points
For anyone saving for retirement, IRAs, employer-sponsored savings
plans, and annuities are often the vehicles of choice, since all
offer tax-deferred compounding. Yet for all three investment
vehicles, the IRS imposes certain restrictions on distributions and
penalties if you do not meet the restrictions. You can easily avoid
these penalties by being aware of them before you invest. Following
are summaries of the distribution requirements for all three
tax-deferred accounts.
IRAs
For both traditional and Roth IRAs, you may begin taking
penalty-free distributions as soon as you reach age 59 ½.
For traditional IRAs, any deductible contributions and investment
earnings will be taxable at your then-current ordinary income tax
rate. For Roth IRAs, qualified distributions will be tax free,
provided you have held the account for at least five years. Any
distribution you receive from an IRA before age 59 ½ will be
subject to a 10% penalty tax imposed by the IRS, in addition to
federal and state income tax.
There are, however, certain circumstances under which the IRS
allows you to take a penalty-free distribution before age 59
½:
- You become permanently disabled.
- You die before age 59 ½ and distributions are made to
your beneficiary or estate after your death.
- You make withdrawals to pay deductible medical expenses that
exceed 7.5% of your adjusted gross income.
- You make withdrawals for a qualified first-time home purchase
(lifetime limit of $10,000).
- You make withdrawals to pay qualified higher education expenses
for yourself, a spouse, children, or grandchildren.
For traditional IRAs, you must begin withdrawals by April 1
following the year in which you reach age 70½. Beyond this
age, the IRS imposes required minimum distribution (RMD) rules that
specify the minimum amounts you must withdraw each year, based on
your age. Note that if you have a spousal beneficiary who is more
than 10 years younger than you, the required minimum distributions
can be based on the joint life expectancy of you and your spouse,
permitting you to stretch out distributions and tax-deferred
compounding. If your distributions in any year after you reach age
70½ are less than the required minimum, you will be subject
to a penalty tax equal to 50% of the difference - so make sure you
adhere to the RMD rules.
For Roth IRAs, you are not required to start taking distributions
at age 70½, as you are with a traditional IRA. When a Roth
IRA owner dies, however, his or her heirs must adhere to the same
minimum distribution rules that apply to traditional IRAs.
401(k)s, 403(b)s, and Other Employer-Sponsored Plans
As with IRAs, you may begin taking penalty-free distributions
from your plan as soon as you reach age 59½. If you separate
from service with your employer and you are at least 55 years old,
you can also avoid paying the early withdrawal penalty. All
earnings and before-tax contributions to the plan will be subject
to ordinary federal and state income taxes as they are withdrawn at
your then-current rate.1 Prior to this, the same 10%
penalty that applies to IRA early withdrawals will also apply and
the IRS will require your employer to withhold 20% of the payment
for income tax purposes.
As with a traditional IRA, you must generally begin taking
required minimum distributions no later than April 1 following the
year in which you turn 70½. 2 However, required
minimum distributions from a 401(k) can be delayed until retirement
if you continue to be employed by the plan sponsor beyond age
70½ and you do not own more than 5% of the company.
The same age-based RMD rules also apply to employer-sponsored
plans. Additionally, the IRS allows qualified individuals to take a
"lump-sum distribution" for which certain favorable tax rules
apply. To qualify as a lump-sum distribution, you must receive all
the amounts you have in all your retirement plans with a company
(including 401(k), profit-sharing, and stock purchase plans) within
a one-year period. If all the terms of the lump-sum distribution
are met, the taxable part of the distribution is taxed at special
rates based on levels for single taxpayers in 1986. You will also
qualify for 10-year forward income averaging if you were born
before 1937.
Some employer-sponsored plans may allow you to borrow as much as
50% of your vested account balance, up to $50,000. In most cases,
if you systematically pay back the loan with interest within five
years, there are no penalties assessed to you. However, if you
leave the company you must pay back the loan in full immediately.
In addition, loans not repaid to the plan within the stated time
period are considered withdrawals and will be taxed and penalized
accordingly.
Annuities
As with IRAs, withdrawals from an annuity before age 59 ½
are taxed as ordinary income and will be subject to a 10% federal
penalty tax. At withdrawal, all investment earnings (but not
contributions) on your annuity will be taxable at ordinary federal
and state rates.
RMD rules do not apply to annuities, distributions from which can
commence at any time after age 59 ½, as specified in the
annuity contract. Keep in mind, however, that the issuing company
may have its own set of rules and penalties. Annuity contracts
often contain surrender charges for withdrawals taken during the
initial years of the contract, so make sure to read the terms of
your agreement closely.
As with all retirement and tax planning matters, be sure to
consult a qualified tax and financial planning professional to
ensure that your planning decisions coincide with your financial
goals.
| Uniform Lifetime Table for Required
Minimum Distributions |
| Age |
70 |
75 |
80 |
85 |
90 |
95 |
100 |
105 |
|
27.4 |
22.9 |
18.7 |
14.8 |
11.4 |
8.6 |
6.3 |
4.5 |
| This table shows required minimum distribution
periods for tax-deferred accounts for unmarried owners, married
owners whose spouses are not more than 10 years younger than the
account owner, and married owners whose spouses are not the sole
beneficiaries of their accounts. |
| Source: IRS Publication 590. |
Points to Remember
- The IRS imposes certain restrictions on distributions from
tax-deferred accounts and penalties if you do not meet the
restrictions.
- For IRAs and annuities, you may begin taking penalty-free
distributions as soon as you reach age 59½. For
employer-sponsored retirement savings plans, you can also avoid
paying the early withdrawal penalty if you separate from service
with your employer and you are at least 55 years old.
- For traditional IRAs, you must begin withdrawals by April 1
following the year in which you reach age 70½. Beyond this
age, the IRS imposes required minimum distribution (RMD) rules that
specify the minimum amounts you must withdraw each year, based on
your age.2
- The required minimum distributions from a 401(k) can be delayed
until retirement if you continue to be employed by the plan sponsor
beyond age 70½ and you do not own more than 5% of the
company.
- RMD rules do not apply to annuities, distributions from which
can commence at any time after age 59½, as specified in the
annuity contract.
- Annuity contracts often contain surrender charges for
withdrawals taken during the initial years of the contract.
1The IRS allows for "in-kind" distributions of
publicly held company stock in a plan, whereby any price
appreciation which occurred while the securities were held in the
401(k) can be treated as capital gains rather than ordinary
income.
© 2011 McGraw-Hill Financial Communications. All rights
reserved.
