Retirement Planning For 30-Somethings: Avoiding Withdrawals
Making withdrawals from your retirement savings will negatively impact your retirement nest egg in several ways. The following are a few:
In order to defer retirement account owners from making withdrawals before retirement, a 10% additional tax is levied on distributions made before you reach age 59.5, unless you qualify for an exception. The exceptions to the 10% early-distribution penalty include distributions that are:
- Made to your beneficiary on or after your death
- Made because you have a qualifying disability as defined by the retirement plan
- Made as part of a series of substantially equal [E1] periodic payments beginning after you separate from service with an employer that sponsors a qualified plan, 403(b) or government 457(b) plan; where the distributions are made at least annually over your life expectancy or the joint or life expectancies of your designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least five years or until you reached age 59.5, whichever is the longer period.)
- Made from a qualified plan, 403(b) or governmental 457(b) plan after you separate from service with the employer that sponsors the plan if the separation occurred during or after the calendar year in which you reach age 55.
- Made to an alternate payee under a qualified domestic relations order (QDRO). A QDRO is a judgment, decree or order assigning you to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent. The QDRO must contain certain specific information such as your name and last known mailing address, the name of each alternate payee and the amount or percentage of your benefits to be paid to each alternate payee. A distribution that is paid to a child or other dependent under a QDRO is taxed to you. A distribution that is paid to a spouse or former spouse under a QDRO is taxed to the recipient of the assets.
- Made to you for medical care up to the amount allowable as a medical expense deduction
- Made in a timely manner to reduce excess contributions
- Made because of an IRS levy
Claiming the Penalty Exception
For the distributions that you receive during the year, you will receive a copy of IRS Form 1099-R from the payor, which is the financial institution or plan administrator responsible for processing plan distributions, tax withholding and tax reporting. Generally, if you qualify for an exception to the 10% early-distribution penalty and provide the necessary documentation to the payor, this exception will be noted on the 1099-R. Should the payor fail to indicate this exception, you may file IRS Form 5329 with your federal tax return to claim the exception.
Qualified plans, 403(b) and governmental 457(b) accounts include withdrawal restrictions that serve to prevent employees from making withdrawals unless they meet certain requirement. As such, if you are considering making withdrawals from one of these plans, you may need to meet one or more of the following requirements:
- Reach Retirement Age: The plan usually includes a definition of retirement age, and can require that you reach that age in order to be eligible to make withdrawals.
- Termination from Employment: If you are no longer working for the employer that sponsors the retirement plan, you are usually allowed to make withdrawals from your account balance.
- Death: Your beneficiaries are allowed to withdraw your account balance after you die. Such withdrawals are not subject to the 10% early distribution penalty, but any pre-tax amount is subject to income tax.
- Disability: If you become disabled, you may be eligible to receive distributions from the plan. Generally, disability is defined as the inability to perform gainful services for an indefinite period. A plan may provide its own definition of disability for purposes of determining eligibility to make withdrawals.
- Termination of the Plan: If the employer terminates the plan, you are eligible to withdraw your account balance.
- In-Service Withdrawal: Unless the plan is a money-purchase plan, it may allow you to receive distributions before experiencing a triggering event. This kind of distribution is referred to as an in-service withdrawal. Some plans limit the availability of in-service withdrawals to cases of employees experiencing financial hardship, which includes instances when you need assets to pay medical bills, a mortgage or rent to prevent eviction, and education expenses. For a particular plan's definition of financial hardship, you should refer to you summary plan description (SPD) or the plan document. The SPD, which must be provided to every participant, is a document that explains the plan provisions in layman's terms.
Any pre-tax amount that you withdrawal from your retirement account will be taxed at your ordinary income tax rate. In addition, the amount could push you into a higher tax rate, which means that the distribution and all other taxable income you receive for the year would be taxed at that higher rate.
If the distribution is made from qualified plan, 403(b) or governmental 457(b) account, the payor is required to withhold 20% for federal income tax unless an exception applies to this withholding rule. This means that if you need a specific amount, you will need to increase the amount you request so that the net amount you receive is sufficient.
You can avoid this mandatory withholding by rolling over the amount to your IRA and then making the withdrawal from the IRA. Withholding taxes from distributions from IRAs are optional, which means that you can choose to waive withholding and pay any income tax due. If you choose this option, take care to ensure you fall short of any estimated income tax that you are required to pay for the year, as IRS assessed penalties may apply.
Loss of Tax-Deferred Growth
One of the benefits of saving in a tax-deferred retirement plan is the compound effect of earnings on earnings, and the option to defer paying income tax on any pre-tax amount until retirement, and in some cases, allowing the account owner to make withdrawals during years when the amount would be taxed at a lower rate. If the account is a Roth IRA, the negative effect of making an early withdrawal is compounded, as the tax-deferred earnings could be tax-free when distributed.
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