Retirement Plan Distribution

The rules regarding the taxation of distributions from your 401(k) plan or IRA are complicated, if not mind numbing. There's much too much even to explain in one sitting, let alone absorb. However, some questions pop up with frequency. Here are three of them and answers that may provide you with some guidance.

I'm about to retire. My 401(k) plan offers several options. One choice is to roll over my account balance directly into an IRA. Another is to keep the money right in the plan. Is one choice better than another?

Of course, everyone's circumstances—and 401(k) plans—are different, so it's hard to generalize. The answer may depend upon how happy you are with the investment choices offered by the plan and the administration of the plan by your employer.

If you've accumulated a substantial sum, and are interested in continuing to shelter as much of your retirement money as you can for as long as you can, keeping your assets in the plan may have an impact on your estate planning. If your spouse is your beneficiary, he or she is entitled to roll over the distribution directly from the plan into his or her own IRA at your death, and tax deferral can continue—less any required annual distributions once he or she reaches age 70 1/2 (more on this below). If your spouse then, in turn, names your children as beneficiaries of an IRA, at your spouse's death, your children will be entitled to “stretch” the IRA distributions over their own life expectancies. Generally, when more than one child is named as a beneficiary of a “stretch IRA,” the distributions are based upon the life of the oldest child.

The same scenario will work if your spouse is the beneficiary of your plan account balance. But if your children are the beneficiaries of your company plan account, they may not necessarily be able to stretch it. Although the tax laws allow for it, very often company plans won't permit the stretching out of distributions because of the administrative hassles. Instead, company plans often prefer to pay out the account balance to beneficiaries when an employee dies. In that case beneficiaries only will be able to stretch out the distributions for a maximum of five years. You can fall into that same trap if your spouse is named your primary beneficiary and your children are named contingent beneficiaries (meaning that they inherit in the event that your spouse dies before you do) and your spouse does die before you do.

I understand that I must begin taking money out of my 401(k) or IRA at some point. When must I begin receiving distributions, and what would be the amount?

Distributions from your company plan or IRA must begin no later than the April 1 of the year following the year in which you reach age 70 1/2 or when you retire, whichever date is later. However, participants who own more than 5% of the sponsoring employer (such as a sole proprietor or a partner in a partnership), or a shareholder in a corporation that owns more than 5% of the equity of the company sponsoring the plan, don't have the option of waiting until they retire to begin receiving distributions from the plan.

Your plan account or IRA must distribute an amount that is expected to exhaust your balance in the plan or IRA over your life expectancy. The IRS supplies a standard table that will apply in almost all cases. The math is simple: The amount in your plan account or IRA is divided by the age factor in the table. For example, according to the IRS table, at age 70 your life expectancy is 27.4 years, or 3.65% of the amount in your plan or IRA. So, if your balance is $500,000, the distribution is $18,250.

If your beneficiary is your spouse, and he or she is more than ten years younger than you, you may use a life expectancy based upon your joint lives.

Whatever the distribution amount that you receive, you must, of course, pay tax at regular federal income tax rates.

What happens if I don't take enough from my Rollover IRA?

If you fail to take the full required distribution, you'll be faced with what is referred to as an “excise tax.” It's a potentially heavy penalty: 50% of the minimum amount that should have been distributed—in addition to the regular tax that you owe on the distribution.

When you feel that you missed the deadline for a reasonable cause, you may request a waiver of the 50% excise tax. You can write a letter of explanation and attach it to your tax return (Form 1040) along with Form 5329 [Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts ], which you are required to file to report your shortfall. You must pay the tax that you owe up front and withdraw the shortfall amount from the plan or IRA. If the IRS decides in your favor, the excise tax that you paid will be refunded to you.

Tip: Contact your plan sponsor or the custodian of your IRA to see if you can arrange for automatic distributions on a predetermined date. If you can't, make sure that you make your distribution requests far in advance of the deadline (one recommendation is two months). And always review your statements to make certain that the correct amount was distributed from your account or IRA.

If you are expecting to receive a payout from your 401(k) plan or are approaching the time when you will need to begin receiving distributions from an IRA, we recommend that you discuss your options with a tax professional. We would be glad to be part of that discussion as well.

(April 2005)
© 2006 M.A. Co. All rights reserved.
Any developments occurring after January 31, 2006, are not reflected in this article.