Whenever someone pulls money out of a retirement account (IRA, 401(k), etc.), they could find themselves subject to three possible tax situations and generally facing one of three needs. There are different rules for those under age 59½, over 70½ and those in between. And when it comes to withdrawal needs, people usually are in a “forced to,” “would like to” or “optional” situation.
If you are under the age of 59½, retirement plans are typically the last place you want to pull money from, but there are exceptions. Regardless of your age, understand that tax-qualified money (401(k) accounts, IRAs, pension plans, etc.) grows tax deferred and becomes taxable when funds are pulled out. (For more, see: 5 Tax(ing) Retirement Mistakes.)
The taxes owed are not subject to the lower capital gains rates but rather calculated at higher marginal bracket. Also keep in mind that if you are under 59½, there are federal and state penalties for early withdrawal, but there are some exceptions for which you could qualify.
If you are over 70½, you are “forced” to take out required minimum distributions (RMDs) based upon a life expectancy table provided by the IRS. Otherwise, there is a 50% penalty for missing a distribution and you owe taxes as well.
If you are between the ages of 59½ and 70½ that is considered “open territory.” You can take out as much or as little from your available retirement accounts without any government rules to be concerned about as long as you pay the taxes on those distributions.
If you need funds and are under 59½, you could utilize the IRS rule 72(t) to avoid the 10% federal penalty (as well as California’s 2.5%). In order to activate this clause, you have to be separated from service (i.e., not employed), distributions must run a minimum of five years or to age 59½, whichever is longer, your distributions must follow one of the approved IRS calculation methods and you can’t modify the withdrawal (except in the case of death or disability).
There are some additional situations where penalties may be avoided, but taxes are still levied on the distributions. These include, but are not limited to: a qualified employer plan where separation from service occurred after age 55, distributions for deductible medical expenses, military exemptions where active duty is involved, public safety employees separated from service over the age of 50, an unemployed person paying for health insurance premiums, first time home buyer limited exemption and qualified education expenses.
Avoiding Withdrawal Mistakes
Before acting, make sure you speak to your CPA to ensure an exemption pertains to your situation. The rules and procedures can be quite complex, so familiarize yourself with the regulations at www.irs.gov. Over the years, the IRS has become less forgiving when withdrawal mistakes are made and the procedure to fix an error can be costly and time consuming.
Remember, these retirement accounts have not been taxed before, so most people look at these as the last place to pull money. But if you are going to be in a low tax “employment transition” year, then you may want to consider a Roth conversion or take withdrawals when your marginal rate is low. If your financial situation is so dire that bankruptcy is a real possibility, speak to an attorney as soon as possible. Your retirement accounts have rules that can protect them from creditors, so you need to be aware of your rights before you take money out. (For more from this author, see: Make Your Estate a Gift, Not a Burden.)
Disclaimer: Mission Wealth is a Registered Investment Adviser