Making Your Money Last
Six Critical Retirement Missteps
Tripping up on your payout plan can cost you thousands of dollars in taxes.
By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
November 12, 2007
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EDITOR'S NOTE: This article is from Kiplinger's Success With Your Money special issue. Order your copy today.
When it comes to making crucial decisions about retirement payouts, you don't get do-overs. Instead of checking off boxes and signing forms before rushing off to your retirement party, take time to weigh your options. Making mistakes "can be a very expensive learning curve," says Mark Cortazzo, head of Macro Consulting Group, in Parsippany, N.J. Avoiding them can save you thousands of dollars in taxes.
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MISSTEP #1: Withdrawing money too soon
If you tap your retirement funds before age 59 1/2, you'll owe a 10% early-withdrawal penalty on top of the federal and state income taxes you'll pay on each distribution. There are exceptions that let you withdraw your money early without a penalty -- but only if you follow the rules.
For example, if you are at least 55 when you leave your job, you can take distributions from your 401(k) without paying a penalty (but you will still owe income taxes on your withdrawals). The key is to keep your money in your employer's plan when you retire. If you transfer it to an IRA, you'll lose the "55-and-out" option.
Jim Conrad of Huntertown, Ind., planned to tap his 401(k) when he retired last fall after 33 years in the auto industry. But there's a catch: Although you qualify for penalty-free access to your money if you are 55 or older, your employer may limit the number of distributions you can take. That's what happened in Conrad's case, forcing him and his wife, Colleen, to come up with Plan B. "We know we'll need to tap some of our savings for income," he says. "We're just trying to figure out the best way."
MISSTEP #2: Interrupting annual payments
So Conrad, 55, is considering another early-out strategy. If he rolls his 401(k) into an IRA, he can make withdrawals penalty-free (but will still owe income taxes) as long as he takes "substantially equal periodic payments" based on his life expectancy for at least five years or until he's 591/2, whichever is longer. There are three ways to calculate these so-called 72(t) payments (named after the section of the tax code that waives the penalty), all of which can be done using the free calculators at www.72t.net.
Let's say you have $500,000 in your IRA when you begin taking distributions at age 56. The IRS life-expectancy table estimates that you will live another 28.7 years. Under the simplest minimum-distribution method, you would have to withdraw $17,422 the first year, then divide your subsequent IRA balances by your declining life expectancy for each of the next four years. The goal is to give yourself early access to some of your retirement savings without wiping out your account. The other two calculation methods would result in payouts of more than $35,000 per year.
If you want to take out less money, you can split your IRA into separate accounts and set up a periodic-payment plan with just one of them. The reverse calculator at www.72t.net lets you plug in the amount you want to receive each year and then tells you how much you need to allocate to the account.
But once you start, you can't change your mind. If you deviate from the payout schedule, you'll owe a 10% penalty retroactive to your first withdrawal, plus interest. Say you took out $75,000 in 72(t) withdrawals over four years, then stopped before reaching the five-year threshold. You would owe more than $8,000 in penalties and interest. Ouch!
MISSTEP #3: Taking a check
If you decide to transfer your 401(k) or other retirement assets to an IRA, make sure they go directly to the new custodian. If your employer cuts you a check, the company will be required to withhold 20% for taxes and you will have to roll the entire amount -- including the 20% you didn't receive -- into an IRA within 60 days. Any money not deposited into the IRA would be treated as a taxable distribution, subject to taxes and early-withdrawal penalties.
Reader Comments (9)
Posted by: G. Monson at 11/12/2007 12:22:10 PM
I do not understand the math in Misstep #6 that totals to $83,000 in income at 15% tax rate
Posted by: Mary Beth Franklin at 11/13/2007 11:34:19 AM
Step six assumes a retired married couple's only income is $83,000 in IRA distributions. The first $19,600 is tax free ($10,700 standard deduction plus extra deductions of $1,050 each for 65+, and two personal exemptions at $3,400 each.) Their taxable income is $63,400 ($83,000 - $19,600 = $63,400.)The top of the 15% bracket for married couples is $63,700.
Posted by: Don Weddle at 11/13/2007 11:59:05 PM
Retirees with sizeable IRAs, who want to supplement their social security with reasonable distribution must remember (I found out later to my surprise) that your Social Security payments will be curtailed by that IRA distribution, depending on how much income these and other investments generate. As an example, federal bonds do not affect Social Security payments. But Municipal Bonds, tax free, will also cut back the Social Security allowance. These things must be considered in retirement planning. The Social Security website has tables to guide us.
Posted by: John R. at 11/15/2007 12:50:38 PM
How is Joe Sixpack ever supposed to keep track of all this?
Posted by: Joseph Bauer at 11/28/2007 10:05:06 PM
Nonwork sources of income, such as:pensions,IRA distributions,inheritance payments do not count as wages for the earnings test.
Posted by: Andy W at 12/05/2007 12:15:27 PM
"How is Joe Sixpack ever supposed to keep track of all this?" You have 3 choices really. 1) drive yourself to drink trying to figure it all out yourself. 2) pay a money manager or tax attorney big bucks to show you the loop holes. 3) get it wrong and pay the gov't way more in taxes than you need to. There are entire industries founded on things like this that are made intentionaly complicated. The tax code is one example, and probably the biggest.
Posted by: A. Counting at 12/05/2007 12:23:35 PM
John R, Joe Sixpack won't figure this out. That is why so many Americans are not prepared for retirement. Me? I am basing all my hopes on winning the lotto! :)
Posted by: M at 12/05/2007 02:45:09 PM
to John R.: Yes this stuff seems daunting at first -I know! (I am a clerk in an office and type for a living.) But take an interest in retirement like you'd do with a sport such as baseball and football - even try making a game of it to spar back and forth with others along your learning curve, since there's nothing like a little verbal competition to get us energized and focused on a subject long enough to really understand it. Make it fun always! It's also akin to the same way you keep your job: Learn it inside and out - study it bit by bit - perhaps setting a realistic goal each day of memorizing 2 rules thouroughly and completely. Test yourself with friends or family - verbally reinforcing what you've just memorized. By the time even 6 months passes, you will be able to talk like a financial pro. Also, write down "bits" of financial retirement info on post-it notes and use them to start amassing knowledge every single day. Maybe just one note gets memorized per day, but you will be surprised at how fast your financial knowledge will grow.
Posted by: tom wagner at 01/02/2008 03:50:17 PM
you made a good point on the tax issue and I chose to hedge on converting to a roth/ira. further, not trusting the goverment to not change the rules, I only converted my wifes IRA, as we won't really know the effective tax bracket at that point in time....we might have a national sales tax with an act of God.