When must you start withdrawing the funds in your retirement plans? And what happens if the funds aren't
withdrawn before you die? To what extent will your heirs be taxed? The rules are complex but there are ways
the savvy taxpayer can maximize the tax shelter.
The basic rule is that you must begin withdrawing funds--and incurring taxes on these withdrawals--no later
than April 1 of the year after you turn 70 1/2. This rule exists so that retirement funds
will be distributed whether or not spent during what for most people is their retirement years.
An exception to this general rule is that, where your retirement plan permits, you do not need to begin
these mandatory withdrawals until you retire if you are still employed when you reach the mandatory
withdrawal age. The exception doesn't apply where you're a 5 percent or more owner of the business that
provides the plan, or to withdrawals from traditional IRAs--in those cases, you are subject to the mandatory
The law has specific rules about how fast the money must be taken out of the plan after your death. These
rules curtail the ability to prolong a tax shelter that started out to aid your retirement.
The rules are complex, but here's a general overview of the timing of retirement plan distributions which
will help avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules,
professional guidance in this area is strongly suggested.
Related Guide: The tax treatment will be dictated not only by the timing
of the withdrawal (i.e., when to take it) but also by the
form of the withdrawal (i.e., how to take it). This
Financial Guide discusses the "when." For a discussion of the "how," please see the Financial Guide: RETIREMENT PLAN DISTRIBUTIONS: HOW
to Take Them.
Withdrawal While You're Alive
Before You Reach Age 70 ½
Until the year you reach 70 1/2, you need not take your money out of your retirement account, although your
employer's plan might require you to do so. In fact, there will usually be a 10 percent early-withdrawal
penalty if you make withdrawals from an IRA before age 59 1/2. Between the ages of 59 1/2 and 70 1/2; you
pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax
contributions you made.
Once You Reach Age 70 1/2
Once you hit 70 1/2, withdrawals must begin. Technically they can be postponed until April 1 of the year
following the year you reach 70 1/2 say April 1, NaN, if you reach 70 1/2 in 2019. But waiting until April
1 means you must withdraw for two years--NaN and in . To avoid this income bunching and a possible
higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 70 1/2.
IRS has greatly simplified and relaxed the withdrawal rules over the years to increase the retirement plan
tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.
The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your
Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values
as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table
(the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The
owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the
Example 1: Joe reaches age 70 ½ in October of this year. Retirement plan
assets in his IRA totaled $600,000 at the end of last year. The IRS number for age 70 is 27.4. Joe must
withdraw $21,898 ($600,000/27.4) this year.
Example 2: Two years from now Joe is 72 and his IRA was $602,000 at the end of the
preceding year (when Joe reached age 71). The IRS number for age 72 is 25.6. Joe must withdraw $23,517 two
The distribution period in the IRS table in effect assumes distribution over a period based on your life
expectancy plus that of a beneficiary 10 years younger than you. (Distribution after your death is based
on the actual life span or life expectancy of your actual beneficiary-see "Withdrawal after You Die"
below.) Only where your designated beneficiary is a spouse more than 10 years younger than you is his or
her actual life expectancy used to figure the withdrawal period during your lifetime. You may use these
rules to prolong distribution for 2003 and after, even though you have been taking withdrawals over a
shorter period under previous rules.
Under the current rules, the life expectancy of your designated beneficiary (if you have one) is
irrelevant in figuring your withdrawal period (except for a beneficiary spouse more than 10 years
younger). Thus, you can change your designated beneficiary at will, or replace one who died, without
affecting your withdrawal period (except for a change to or from a spouse more than 10 years younger).
Caution: You can always take out money faster than
required--and pay tax on these withdrawals. However, the tax code is strict about minimum withdrawals. If
you or your beneficiaries or heirs fail to take out what's required, a tax penalty will take 50 percent of
what should have been withdrawn but wasn't.
Withdrawal after You Die
Designating a beneficiary is no longer needed to prolong distributions during your lifetime (except where
your beneficiary spouse is more than 10 years younger than you). But it's still needed to prolong the
distribution during your beneficiary's lifetime, should the beneficiary want that (some will want the money
Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets.
You may change the beneficiary later without affecting the amount you withdraw (except for a change to or
from a spouse more than 10 years younger).
The rules as to how fast your beneficiaries or heirs must withdraw funds from your account and pay the
income tax-differ, depending on your beneficiary choice.
Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse
has options that no other beneficiary has.
Rollover. A spouse beneficiary of your IRA can elect to treat the balance in your IRA as his
or her own IRA (like a rollover). This provides the optimal extension of the withdrawal period if your
spouse is younger than you since your spouse doesn't have to start withdrawing funds until he or she
70 1/2. At age 70 1/2, your spouse can then use the period in the IRS table or a longer one if he or she
then has a spouse more than 10 years younger. A rollover isn't allowed if a trust is a beneficiary, even
if the spouse is the trust's sole beneficiary. A similar extension is allowed for a balance you might
leave in a qualified retirement plan: your spouse can roll it over into his or her IRA. And your spouse
can roll over a distribution from your retirement plan to another retirement plan in which he or she
participates, as well as to an IRA.
Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the
money in the deceased participant's account. There's no 10 percent early-withdrawal penalty if the
takes funds out of your account, but that penalty would apply if the
spouse rolled over the money into his or her own IRA and tapped it before reaching 59 1/2.
Tip: Leaving the money in your account makes sense if your spouse
is under age 59 1/ 2 and needs the money soon after your death.
Tip: If your spouse remains a beneficiary, he or she doesn't have to start withdrawals
until you would have reached age 70 ½ after which withdrawals will be taken under the IRS table.
Generally, there will not be an estate tax on retirement plan assets left to a spouse and the spouse will
pay income taxes only as funds are withdrawn.
Someone Other Than Your Spouse. A child or other non-spouse beneficiary of an IRA can choose to
start withdrawals by the end of the year after your death and spread distributions over his or her
own life expectancy. This method extends the payout period and the tax deferral. The life
expectancy for a 55-year-old, for example, is 29.6 years.
A non-spouse beneficiary of funds in a retirement plan can elect after 2006 to have the funds rolled to an
IRA, and then spread withdrawals as described above.
Tip: The required payout schedules set the minimum that can be
withdrawn. The beneficiary can always take out more.
If you name your children as group beneficiaries, minimum payouts are based on the life expectancy of the
eldest child. On the other hand, if you create a separate share or account for each child, the child uses
his or her own life expectancy.
No beneficiary. If you die before April 1 after the year you reach age 70 ½ having named no
beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity),
all funds must be distributed and income taxes paid within five to six years of your death. Heirs don't get
the option of using their own life expectancy.
If you die on or after that April 1 date without having named a beneficiary or having named your estate as
the beneficiary, the money must come out by the end of the period remaining under the IRS table. For
example, at age 80 the table period is 18.7. On a death at age 80, the estate or heirs would have 18.7 years
to complete withdrawal.
Death before distributions begin. If you should die before the time (age 70 ½) required distributions
are to begin, minimum distributions to your beneficiary can be spread over his or her life expectancy.
Estate tax. There may be an estate tax on retirement funds left to someone other than your
spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer
who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.
The above discussion covered the general rules as to the withdrawal of retirement plan distributions both
before and after you die. Now let's look at some specific tax planning techniques, particularly as regards
the estate tax, for minimizing the tax bite when the funds accumulated in your retirement accounts
(including pension and profit-sharing plans, 401(k) plans, IRAs and rollover IRAs) are passed on to your
How Your Heirs Are Taxed
The general rule is that, while there may be a estate tax bite at your death, inherited
assets are received income-tax-free by your heirs. Unfortunately, this general rule doesn't apply to
money in a retirement plan. Whoever gets the money will incur income tax on it, unless it's left
to charity (more on giving retirement assets to charity below).
Example: If you gave your wife a $500,000 stock-and-bond portfolio, she will
not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will
not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will
subject to income tax on it, more or less as you would be if you had received the distributions yourself.
(Moreover, there may be a further estate tax as well.)
The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates,
except for after-tax investments, which come out tax-free. There are, however, the following key exceptions
- On a lump sum distribution, heirs of persons born before 1936 can sometimes claim tax relief.
Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments,
the interest element is taxable.
The value of a stock bonus is taxable when received as ordinary income, less unrealized appreciation,
and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir
can roll over from your account.
There's no early withdrawal penalty on what your heir withdraws after your death, even if the heir is
under age 59½, but in general, if your spouse is your heir and rolls over your retirement account to his
or her IRA, a withdrawal from the IRA while under age 59 1/2 is subject to the penalty.
Some Tax Planning Opportunities
The federal estate tax isn't a major problem for most Americans. Less than two percent of those who die in
any year leave an estate that's hit by the estate tax; but the larger a taxpayer's retirement account, the
more likely it will be cut down by the federal estate tax on top of the federal income tax described
Unlike the income tax, which is collected only as amounts are distributed--and thus is deferred on
annuities and the like--the estate tax is collected up front, at the owner's death, on the present value of
One common planning technique-making lifetime gifts to reduce your taxable estate is impractical for
retirement accounts. Even where you might be able to give part of your retirement account away (as with an
IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter
survives for your donee. But there are more practical techniques:
Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets
to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the
longest period possible.
If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and
income taxes on this amount while achieving charitable goals.
A charitable remainder trust is a sophisticated way to benefit family, as well as charity at a
reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from
retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is
allowed for the present value of what will go to the charity.
Consider buying life insurance to pay estate tax that can't be avoided (perhaps because you want a
large retirement account to go to someone other than a spouse or charity). The insurance proceeds will
exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to
tax). With proper planning, the withdrawn funds can escape estate tax as well.
Retirement Plan Distributions: How To Take Them
If you are thinking of retiring soon, you are about to make a major financial decision: how to take
distributions from your retirement plan. This Financial Guide will discuss your various options. And, since
the tax treatment of these distributions will influence your decision, we will also review the tax
You may have a number of options as to HOW you can take retirement plan distributions, i.e., your share of
company or Keogh pension or profit-sharing plans (including thrift and savings plans), 401(k)s, IRAs, and
stock bonus plans. Your options depend (1) on what type of plan you are in and (2) whether your employer has
limited your choices. Essentially, you can:
- Take everything in a lump sum.
- Take some kind of annuity.
- Roll over the distribution.
- Take a partial withdrawal.
- Do some combination of the above.
As you will see, the rules on retirement plan distributions are quite complex. They are offered
here only for your general understanding. Professional guidance is advised before taking retirement
distributions or other major withdrawals from your retirement plan.
Before discussing the specific withdrawal options, let's consider the general tax rules affecting (1)
tax-free withdrawals and (2) early withdrawals.
The tax treatment will be dictated not only by the form
of the withdrawal (i.e., how
to take it) but also by the
of the withdrawal (i.e., when
to take it). This
Financial Guide discusses the "how."
For a discussion of the
please see the Financial Guide RETIREMENT PLAN DISTRIBUTIONS:
WHEN to Take Them.
Tax-free Withdrawals. If you paid tax on money that went into the plan, that is if it was
made with after-tax funds that money will come back to you tax-free. Typical examples of after-tax
- Your non-deductible IRA contributions.
Your after-tax contributions to company or Keogh plans (usually, thrift, savings or
other profit-sharing plans, but sometimes pension plans).
- Your after-tax contributions to 401(k)s (in excess of the pre-tax deferral limit).
Early Withdrawals. Tax-favored retirement plans are meant primarily for retirement. If you
withdraw funds before reaching what the law considers a reasonable retirement age-age 59 ½--you usually will
face a 10 percent penalty tax in addition to whatever tax would ordinarily apply.
At age 47, you withdraw $10,000 from your retirement account (and do not roll over the funds).
That $10,000 is ordinary income on which you'll owe regular tax at your applicable rate plus a 10 percent
penalty tax ($1,000).
As with any other tax on withdrawal, the 10 percent penalty doesn't apply to any part of a withdrawal that
would be tax-free as a return of after-tax investment
There are several ways to avoid this penalty tax. The most common are:
- You're age 59 ½ or older.
- You're retired and are age 55 or older (however, this does not apply to IRAs).
You're withdrawing in roughly equal installments over your life expectancy or your joint-and-survivor
life expectancy (discussed later).
- You're disabled.
The withdrawal is required by a divorce or separation settlement (here, too, this does not apply to
- The withdrawal is for certain medical expenses.
- The withdrawal is for health insurance while unemployed (also available to self-employed).
For IRAs only: The withdrawal is for certain higher education expenses and for first-time home
purchases (up to $10,000).
Now let's review the basics for each of the options for taking retirement plan distributions and then
discuss the tax planning for each option.
Take Everything In A Lump Sum
You might want to withdraw all retirement funds in a lump sum, perhaps to spend them on a retirement home
or assisted living arrangement, on a second home, or to buy or invest in a business. Or you might want to
take everything out of a company account because you mistrust leaving funds with a former employer or to
take control of investment decisions, although here a rollover (discussed later) might be preferred. Maybe
you have to take a lump sum, as some employers will require, though here, too, a rollover option is probably
Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans,
but may also happen in other plans. Put another way, while plans generally allow lump sum distribution, the
employer may have decided to preclude the lump sum form.
While your funds remain in the plan, earnings on the investment assets grow tax-free.
The tax shelter ends once the funds are withdrawn. Preserving this tax shelter is one reason to decide not
to withdraw the funds at all or to decide against withdrawing everything in a lump sum. The tax shelter
continues, in one form or another, for funds withdrawn as annuities and for funds left in the plan when
there's a partial withdrawal of funds. And the shelter continues on rollovers.
Special tax relief applies, in certain cases, for those who withdraw their pension assets in a lump sum.
For most, this relief comes in the form of "forward averaging," which is also known as the 10-year tax
Forward averaging reduces your tax below what it would be if figured at regular progressive rates. You will
pay tax in one year (for the year you receive it) as if the lump sum amount was received in equal
installments over 10 years. Forward averaging isn't allowed if any part of the account is or was rolled over
to an IRA.
Capital gain treatment for lump sums is available only for those born before 1936 and only with respect to
plan participation before 1974. You will need to report the taxable part of the distribution from
participation before 1974 as a capital gain (if you qualify) and the taxable part of the distribution from
participation after 1973 as ordinary income using the 10-year tax option to figure the tax on the part from
participation after 1973 (if you qualify).
It's a "lump sum" if you take out everything left in your account in a single calendar year. If you took
$50,000 last year and $250,000 this year, and nothing is left, $250,000 is the lump sum. If you took
$250,000 last year and $50,000 this year and nothing is left, $50,000 is the lump sum. In general, lump sum
relief is available only once in a worker's lifetime.
You may also report the entire taxable part as ordinary income or roll over all or part of the
distribution. No tax would be due on the part rolled over and any part of the distribution that is not
rolled over is reported as ordinary income.
Because lump sum withdrawal ends the tax shelter, it's rarely the road to maximizing
wealth. Retirees will usually do better with arrangements that preserve the shelter, through rollovers,
annuities or partial withdrawals.
Roll Over The Distribution
Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from
a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.
Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do
this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces
the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan,
you might make the rollover as part of a decision to terminate your plan or your business.
A rollover to your own IRA can give you flexibility in dealing with the funds (for
example, so you can invest in options or create a separate IRA for each beneficiary) that would not be
available for funds left in your employer's plan. Rollovers can be of the entire retirement account or only
part of the account.
Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to
expand investment options or to create several IRA accounts. Rollovers also can be made from one pension,
profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or
set up a new Keogh plan because of starting a new business after you retire.
Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement
distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other
consequences, some undesirable:
Federal law grants a person no rights in his or her spouse's IRA. Thus, a plan
participant's rollover will strip the participant's spouse of rights the spouse had under the plan from
which the assets are being removed. In the case of a pension plan, the spouse has a measure of protection
because the spouse must approve the transfer that will forfeit his or her rights. However, no such approval
is required in the case of 401(k)s or profit-sharing plans. Thus, a rollover from such plans can eliminate
spousal rights. (Employers sometimes provide spousal rights that federal law does not require.)
A rollover will eliminate the chance of lump sum tax relief, unless the IRA was
just a conduit for the movement of funds between retirement plans.
In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter
period. IRA distributions must begin at age 70 ½, but distributions from a retirement plan can be postponed
beyond that until the participant retires, unless he or she is an owner of the business.
A rollover from an IRA to a retirement plan could also get greater creditor
protection than if left in an IRA.
Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:
After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to
defined contribution plans, but not to defined benefit plans.
You can't roll over amounts you're required to withdraw after reaching age 70 ½, or amounts you're due
to receive under a fixed annuity.
If you do the rollover yourself-personally withdrawing funds from one plan and
moving them to another-the plan you're withdrawing from must withhold tax at a 20 percent rate on the
withdrawal. To avoid tax on the 20 percent withheld, you'll have to come up with that amount from elsewhere
and add it to the rollover IRA. (The tax withheld can be taken as a credit against the year's tax
liability.) On the other hand, a direct rollover (having the funds transferred directly from the
transferring plan to the receiving plan) avoids withholding.
If you do the rollover yourself, the withdrawn funds are taxable if they don't
reach the rollover destination within the deadline (generally, 60 days). Therefore, the least risky way to
roll over funds is a direct rollover.
Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or
(2) sell it and transfer the cash.
The rollover is not tax-free if cash is withdrawn, used to buy investment assets,
and the new assets are then transferred to the new plan.
Take A Partial Withdrawal
Partial withdrawals are withdrawals that aren't rollovers, annuities or lump sums or don't qualify for lump
sum forward averaging or capital gain relief. They include certain withdrawals that you can make while you
are still working as well as withdrawals at or after retirement. They may be made for investment or
consumption, including education and health care. Because they are partial, the amount not withdrawn
continues its tax shelter.
A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum,
rollover) of the balance left in the plan.
Before retirement, partial withdrawals are fairly common with profit-sharing plans, 401(k)s, and
stock bonus plans. After retirement, they are fairly common in all types of plans (though least common with
defined-benefit pension plans).
A partial withdrawal is taxable (and can be subject to the penalty tax on early withdrawal) except to the
extent it consists of after-tax funds. The withdrawal is generally tax-free in the proportion the after-tax
investment bears to the total retirement account.
Your retirement account totals $100,000, which includes an after-tax investment of $10,000. You
withdraw $5,000. The withdrawal is tax-free to the extent of $500 ($10,000/$100,000x$5,000).
The tax-free portion is computed differently for plan participants who were in the plan on
Do Some Combination Of The Above
Combination withdrawals are quite complex and beyond the scope of this Financial Guide.
For an overview of how states tax retirement plan withdrawals, see State Taxes On Retirement Plan
Life Insurance Options
Here are your typical options where whole life insurance is held for you in a retirement plan:
Your employer surrenders the policy to the insurance company for its cash surrender value, which it pays
over to you.
- Your employer trades in the policy for an annuity on your life.
- Your employer distributes the policy to you.
- Some mix of the above, such as getting some cash proceeds and an annuity.
The tax shelter ends when cash is received. Otherwise, it continues, to some degree.
Assets Withdrawn In Kind
In general, assets withdrawn in kind (i.e., withdrawn in the form held by the retirement plan, rather than
withdrawn in cash) are taxed at their fair market value when received, reduced by after-tax investment.
Stock distributed by a stock bonus plan. Your after-tax investment in the stock comes back
tax-free and you pay no tax on the stock's appreciation in value until you sell it. But you have the
option to pay tax on the value when received.
Annuity contract. These aren't taxed when distributed. You're taxed under the annuity rules
above on annuity payments as received.
Insurance policy. If you convert the policy to an annuity contract within 60 days, the
distribution is tax-free. However, you're taxed under the annuity rules as payments are received. If you
keep the policy, you're taxed on the policy's cash value (less your after-tax investment).
The Economics Of Retirement Annuities
Retirement annuity economics are built around the straight life annuity, where the retiree receives a
certain amount for life, however, long or short that might be. This amount stops at the retiree's death. The
cost of such an annuity is computed, and that's the cost the employer is obligated to provide.
However, you may want, or be obliged to take, something other than a straight life annuity, such as:
A fixed-term annuity, whereby the annuity will continue for a fixed term (say, ten years) even though
you die before the end of this term. (This additional benefit is called a "refund feature.")
- A joint and survivor annuity, where the annuity is payable over two lives instead of one.
These types of annuity are worth more than the straight life annuity. But the employer isn't obliged to pay
for more than the cost of a straight single life annuity. So if you opt for something other than straight
life, the amount you collect each period will be correspondingly reduced to the "actuarial equivalent" of
Can Creditors Reach Your Retirement Assets?
Federal law generally protects your retirement assets or accounts
against claims of your creditors so long as the assets remain in the
retirement plan, except for unpaid federal taxes. Generally, this
protection is in federal labor law (ERISA). Protection denied
under labor law is provided under bankruptcy law (if the case is begun
after October 16, 2005) to:
Keogh plans where the Keogh owner (or owner and spouse) are the
only ones in the plan and
IRA plans, up to the amount rolled over from retirement plans,
plus up to $1 million (which the bankruptcy court may increase where
State Taxes On Retirement Plan Distributions
With 50 different state tax systems, only an overview is possible on how states tax retirement plan
withdrawals. Here are the highlights:
A state cannot tax a retirement plan distribution if it imposes no income tax on individuals (Alaska,
Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
A state from which a pension is paid, by an employer or former employer in the state, can't tax the
pension recipient in another state. In other cases, states generally follow the basic federal approach of
taxing retirement distributions as ordinary income (and treating return of after-tax investment as
tax-free). But some states don't follow the federal rules for Keogh or IRA investment. Hence, withdrawals
from such plans can get state tax relief not allowed under federal law.
Some states grant tax relief for a certain dollar amount of retirement income, relief that extends to
retirement plan withdrawals. In some states the relief may look something like the federal credit for the
Rarely if ever, would a state impose a penalty tax on early withdrawal or on inadequate withdrawals
after age 70 ½.
Retirement Assets: Frequently Asked Questions
Will my heirs owe income taxes when they inherit my retirement
Yes, generally under the same rules that would apply to your withdrawals of the same amounts had you
lived--unless it's a Roth IRA. A Roth IRA is exempt from federal income tax as long as the account was
opened five years before any withdrawals were taken.
Also, your spouse can rollover your account to his or her IRA. No early withdrawal penalty applies,
regardless of your beneficiary's age, but a spouse who rolled over to an IRA may owe an early withdrawal
penalty on IRA withdrawals taken before age 59 ½.
Will my heirs owe estate taxes on inherited retirement assets?
Only a small percentage of estates (based on the value of one's assets at death, and including large
lifetime gifts) are subject to the estate tax and there is no estate tax on assets passing to a surviving
spouse or charity. However, if the estate is subject to federal estate tax, (except in 2010, when there was
no estate tax) you can deduct the portion of the federal estate tax that is attributed to the IRA. You also
won't have to pay tax on the portion of withdrawals that are attributed to any nondeductible contributions
made to the IRA.
Is estate tax deferred if my heir will get an annuity?
No. The estate is taxed on the annuity's present value.
How can I minimize or eliminate tax on inherited retirement assets?
You can minimize or eliminate tax on inherited retirement assets by using the following methods:
Leave them to your spouse. This saves money owed to estate tax and helps postpone withdrawals subject
to income tax--provided your spouse takes no withdrawals before age 59 ½.
Leave them to charity. Although there's no financial benefit to the family, again, this saves income
and estate taxes.
Leave them to family for life, with the remainder to charity in the form of a charitable remainder
trust. This reduces estate tax with some benefits to family.
Provide life insurance to pay estate tax on retirement assets. The benefit of this option is that it
provides estate liquidity, avoiding taxable distributions to pay estate tax.
How should I take distributions from my retirement plan?
If your assets are in a tax-favored retirement fund such as a company or Keogh pension or profit-sharing
plan (including thrift and savings plans), 401(k), IRA or stock bonus plan when it comes time to take
distributions you have several options:
- Take everything in a lump sum
- Keep the money in the account, with regular distributions or withdrawals on an as-needed basis
- Purchase an annuity with all or part of the funds
- Take a partial withdrawal (leaving the balance for withdrawal later)
- Take a rollover distribution
- A combination of any of the above
Your retirement assets may be distributed in kind as employer stock, or an annuity or insurance contract.
Sometimes certain withdrawal options may be associated with certain retirement plans, for instance,
annuities are more common with pension plans. Other types of plan favor the other options, but for the most
part most of these options are available for most plans. And more than likely, you'll want to preserve the
tax shelter as long as possible by withdrawing no more than you need at any given time.
Timing your withdrawal can be a factor, too. Withdrawals before age 59 ½ risk a tax penalty. At the other
end, withdrawals are generally required to start at age 70 ½ or face a tax penalty. The only exceptions are
Roth IRAs and non-owner-employees still working beyond that age.
When is it best to take a lump-sum distribution from my retirement
Your personal needs should decide. You may need a lump sum to buy a retirement home or retirement business.
If your employer requires that you take a lump sum distribution, it may be wise to roll it over into an
What should I do about my retirement plan assets in my ex-employer's
plan if I change jobs?
There are several things you might do depending upon your needs:
If you don't need the assets to live on, try to continue the tax shelter and leave the money where it
Transfer or roll over the assets into your new employer's plan--if that plan allows it (this can be
If you've decided to start your own business, set up a Keogh and move the funds there.
Roll them over into your IRA.
Can creditors get at my retirement assets?
In general, employer plans such as your 401(k), IRAs and pension plan funds are protected from general
creditors unless you've used these assets as securities against a loan or you are entering into bankruptcy.
If this is the case, there's a chance they could be seized, but if the money is in a registered IRA, pension
plan, or 401(k), it's more than likely they will be protected in case of bankruptcy (subject to state and
federal law of course).
How will my state tax affect my retirement withdrawals?
Each state is different, but in general, consider the following:
While withdrawals are generally taxable in states with income tax, some offer relief for retirement
income, up to a specified dollar amount.
If your state doesn't allow deductions for Keogh or IRA investments allowed under federal law, these
investments and sometimes more may come back tax-free.
State tax penalties for early withdrawal (before 59 ½) or inadequate withdrawal (after age 70 ½) are
I understand that I'm required to take money out of my retirement
plan after I reach age 70 1/2. Why is that?
Retirement plans offer the biggest tax shelter in the federal system since funds grow tax-free while in the
plan. But the shelter is primarily intended for retirement. So when you reach 70 1/2 (or shortly
thereafter), you must start to withdraw from the plan.
How can I continue the tax shelter for retirement plan assets after
age 70 1/2?
The shelter can continue for a large part of those assets, for a long time, assuming you don't need them to
live on. You can spread withdrawals over a period based on, but longer than, your life expectancy, for
example, over a period of at least 27.4 years if you're 70 1/2 now. You are free, however, to withdraw at a
faster rate--or even all of it--if you wish. The shelter continues for whatever is not withdrawn.
Suppose there are still retirement assets in my account at my
death. Can the shelter continue for those who receive those assets?
Generally, yes. Persons you have named as your plan beneficiaries can withdraw over their life expectancies
(or more rapidly if they wish). The withdrawal period is generally shorter where no individual beneficiary
is named (for example, where your estate is the beneficiary), but your spouse can sometimes spread
withdrawals over a longer period.
Can moving to another state when I retire save me state taxes on my
Money from retirement plans, including 401(k)s, IRAs, company pensions and other plans, is taxed according
to your residence when you receive it.
If you move from a state with a high income tax, such as New York, to one with little or no income tax
(Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming have none), you will indeed save money
on state income tax.
However, establishing residence in a new state may take as long as one year; if you retain property in both
states, you may owe taxes to both.
What is a reverse mortgage?
A reverse mortgage is a type of home equity loan that allows you to convert some of the equity in your home
into cash while you retain home ownership. Reverse mortgages work much like traditional mortgages, only in
reverse. Rather than making a payment to your lender each month, the lender pays you. Most reverse mortgages
do not require any repayment of principal, interest, or servicing fees for as long as you live in your
Retired people may want to consider the reverse mortgage as a way to generate cash flow. A reverse mortgage
allows homeowners age 62 and over to remain in their homes while using their built-up equity for any
purpose: to make repairs, keep up with property taxes or simply pay their bills.
Reverse mortgages are rising-debt loans, which means that the interest is added to the principal loan
balance each month (because it is not paid on a current basis). Therefore, the total amount of interest you
owe increases significantly with time as the interest compounds. Reverse mortgages also use up some or all
of the equity in your home.
All three types of loan plans, whether FHA-insured, lender-insured, or uninsured charge origination fees
and closing costs. Insured plans also charge insurance premiums, and some impose mortgage servicing
Finally, homeowners should realize that if they're forced to move soon after taking the mortgage (because
of illness, for example), they'll almost certainly end up with a great deal less equity to live on than if
they had simply sold the house outright. That is particularly true for loans that are terminated in five
years or less.