Ideally, distributions from your retirement savings account would be deferred until you reach retirement age. However, extenuating circumstances may necessitate making withdrawals before then. If you are faced with such circumstances, consider the following:
Tax Treatment of Distributions
Distributions from your regular savings are non-taxable and would not be subject to the early distribution penalty. As such, it may make good financial sense to make withdrawals from those amounts first. Distributions from your tax-deferred retirement savings account are treated as ordinary income and may increase your tax rate. Distributions from your deferred retirement account are also subject to a 10% early distribution penalty, if the distributions are made before you reach the age of 59.5. The 10% early distribution penalty is waived if you qualify for an exception, some of which are if the distribution is:
- Made to your beneficiaries on or after your death.
- Made because you have a qualifying disability.
- Made as part of a series of substantially equal periodic payments (beginning after separation from service if made from a qualified plan, 403(b) plan or governmental 457(b) plan) and made at least annually for the life or life expectancy of you or the joint lives or life expectancies of you and 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 reach age 59.5, whichever is the longer period.)
- Made to you after separation from service if the separation occurred during or after the calendar year in which you reach age 55, if the distribution is made from a qualified plan, 403(b) plan or governmental 457(b) plan.
- 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 on the plan.
Tax Withholding Rules
Amounts that you withdraw from your regular savings are non-taxable and are not subject to any tax withholding rules. If the withdrawal is made from your IRA, the payor may be required to withhold 10% for federal tax. You do have the option to elect to have no withholding, but since the amount is treated as ordinary income, it may be taxable, and choosing to have income tax withheld from the amount may be recommend by your tax professional.
If the withdrawal is made from a qualified plan, 403(b) plan or governmental 457(b) plan and paid to you, the payor is required to withhold 20% for federal income tax if the amount is eligible for rollover to another retirement plan or retirement account. These withholding requirements may necessitate withdrawing additional amounts, so that the net amount that you receive is sufficient to meet your financial needs. For instance, if you need $100,000 and request a withdrawal of $100,000, you will receive only $80,000. As such, if you may need to withdraw $125,000 in order to receive the $100,000 that you need. Some providers also withhold state income tax, which would also need to be considered.
If you make withdrawals from your tax-deferred retirement account, you have the option of returning the amount by means of a rollover contribution. This would allow you to reinstate the amount to your retirement nest egg. If you plan to rollover amounts that you withdraw, you must ensure that the rollover meets regulatory requirements in order to preserve the tax status and avoid IRS-assessed penalties. The following are the requirements that must be met:
- 60-day rule: Distributions must generally be rolled over within 60 days of you receiving the amount.
- If the distribution is made from an IRA and will be rolled over to another IRA of the same type, only one distribution can be rolled over from that IRA during a 12-month period.
- Generally, the same property that you received in the distribution must be rolled over.
Caution with Employer Stocks
Distributions from your qualified plan account are usually treated as ordinary income, which means that any taxable amount is taxed at your ordinary income tax rate. However, if you have employer stocks in your qualified plan account, the earnings on these stocks could be taxed at a lower rate. The earnings that accrue on employer stocks while it is being held in your qualified plan account are referred to as net unrealized appreciation (NUA).
NUA is taxed at the capital gains rate if the stock is distributed as a part of a lump-sum distribution. While the basis is taxed at the ordinary income tax rate and is included in your income for the year that you make the withdrawal, you have the option of excluding the NUA from your income until you sell the stocks, giving you some flexibility on when to include the amount in your income. This can be advantageous not only for the lower tax rate, but because you can include amount in income when you desire.
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