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Make the Right Decisions on Retirement Plan Distributions


The term "distributions" refers to money withdrawn from a retirement plan. Generally, traditional IRA and 401(k) account holders are eligible to take penalty-free distributions at age 59 1/2, but the IRS doesn't require distributions until you turn 70 1/2. People can take distributions from traditional IRA and employer-sponsored plans prior to age 59 1/2, but the IRS will assess a penalty of 10 percent in addition to income taxes due.
The IRS offers significant tax benefits for IRAs and employer-sponsored retirement plans — investments that are never subject to capital gains taxes — and for 401(k)s, employees are allowed to make contributions on a pretax basis, including untaxed company matches.
There are several scenarios in which an employee will need to decide what kind of distribution to take from a 401(k):

  1. Separation from employer. There are several options the employee can consider: Leave the money in the plan, cash out, roll over into your new employer's 401(k) or roll over into an IRA. Some provisos: Cashing out could have a drastic impact on the balance of money received and on income taxes. The 401(k) plan provider will be required to withhold some funds for federal and state income taxes. Since the entire distribution is taxable, it could possibly bump the employee into a higher tax bracket.
    Rollovers into the new employer's plan or into an IRA won't trigger taxes or penalties. If you roll over your 401(k) to one at your new employer, you can consolidate the two accounts to make it easier to track and manage retirement savings.
    IRA rollovers allow access and offer both a more advantageous tax situation for beneficiaries and less extreme partial withdrawal penalties.
  2. Separation from employer with outstanding 401(k) loan. If you leave the funds in your former employer's 401(k) plan while paying off the loan, you'll benefit primarily because the loan won't go into default, saving you an additional tax payment. What you'll get is a loan repayment time frame, with penalties for deviating from the repayment plan. However, the repayment window after you've separated from an employer can be very short--a couple of months--so you could face penalties if you can't raise the cash quickly.
    If you leave money in your former employer's 401(k) but stop making loan payments, the 401(k) loan default doesn't have a negative impact on your credit but will trigger a taxable event — it's treated as an early withdrawal and the accrued loan interest is also considered income for tax purposes. As with partial withdrawal or cash-out, a defaulted loan will trigger the receipt of a 1099-R, increasing taxable income.
    If you cash out, taxes and penalties will need to be paid on the entire account value — including the loan. You'll get the distribution minus the loan money you already received. Taxes will be taken — the employer withholds money for federal and state taxes. There will also be the 10 percent withdrawal penalty. You cannot transfer a loan from one 401(k) to another plan — the loan will be considered defaulted.
  3. Withdrawing in later years. After age 59 1/2 there's no 10 percent penalty on cash distributions, and most employers will allow the money to remain invested in the 401(k) plan regardless of employment status as long as there's at least $5,000 in the account. Here again there are options: Cash out, which triggers the income tax withholding, or roll over to an IRA or a new employer's plan, allowing the employee to continue to invest on a tax-deferred basis. No taxes will be assessed on a rollover. Some institutions allow the in-kind transfer of company stock to the new account, while others require that company stock be sold; some plans allow the funding of an annuity with no taxes assessed in the transfer. If it is a joint-and-survivor annuity, both the primary account holder and the designated beneficiary receive a monthly payment for the duration of their lifetime. The annuity distributions are subject to ordinary income tax.

After the account holder reaches age 70 1/2, failure to withdraw the required minimum amount annually may result in substantial tax penalties. For traditional IRAs, required minimums have to be taken no later than April 1 following the year in which you turn 70 1/2. The same generally holds true for 401(k)s, with provisos: If you continue to be employed and you don't own more than 5 percent of the company, you don't have to take minimum distributions. These minimum distribution rules don't apply to Roth IRAs.

These are just the basics of what can be a very complicated series of rules that may come with a lot of exceptions.The bottom line: You rarely have to make an instant disbursement decision. So contact a financial professional beforehand to help you decide what's right for you before making a decision.

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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
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