What is it?
IRAs and employer-sponsored retirement plans (e.g., 401(k) and profit-sharing plans) play a central role in retirement planning. After all, the tax benefits are hard to beat. With traditional IRAs and most employer-sponsored retirement plans, pre-tax money is contributed and grows tax deferred. It's not until you take funds out of the account that you pay income tax on the distributions. With Roth IRAs and Roth 401(k)/403(b)/457(b)s, the money that you contribute comes from after-tax dollars, and qualifying distributions are completely income tax free.
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But to get the tax advantages of IRAs and retirement plans, you need to be familiar with the complicated distribution restrictions, requirements, and tax rules that apply to these retirement investments. At their most basic level, the IRS rules try to discourage you from receiving retirement funds too early or from leaving the funds in a tax-deferred plan or account for too long.
Options for taking distributions from employer-sponsored retirement plans and IRAs
Employer-sponsored retirement plans
In general, the Internal Revenue Code and IRS regulations determine the distribution options that are available under employer-sponsored retirement plans. However, employers are not required to offer all of the available distribution options in their plans. Therefore, it is important that you review the specific terms of your plan to see which options are available to you. These provisions normally include a lump-sum distribution of your entire balance under certain conditions, an annuity payout after separation from service, and a rollover to an IRA or another employer's plan. Other distribution options may also be available upon your termination of employment, upon your death, or even while you are still employed.
Whether taxes are due on distributions depends on whether pre-tax or after-tax contributions have been made. Where funds have not been previously taxed, they are generally taxed upon distribution.
Employer contributions, employee pre-tax contributions, and earnings are generally taxed as income when withdrawn from the plan (subject to certain exceptions, such as tax-free rollovers). An additional 10% premature distribution penalty may also be assessed on taxable portion of distributions taken from the plan prior to age 59½ (subject to certain exceptions).
Special rules apply to after-tax Roth 401(k)/403(b)/457(b) contributions. These contributions are free from federal income tax when paid to you from the plan and, if certain conditions are met (a "qualified distribution"), all investment earnings on these contributions are also tax free and penalty free when paid to you.
IRAs
IRA distributions can be made purely at the IRA owner's discretion. The taxation of distributions from IRAs depends on the type of IRA (traditional or Roth), the source of the contributions (pre-tax or after-tax), and whether all tax requirements have been met.
With traditional IRAs, distributions taken from the account may or may not be taxable income. Distributions of contributions are generally taxable only if they were tax deductible at the time you made them. Amounts you contributed that weren't eligible for a tax deduction (after-tax contributions) can generally be withdrawn income tax free (because tax has already been paid on those dollars). By contrast, distributions of investment earnings from these accounts are always taxable.
Your age is also a key factor in terms of the tax consequences and advisability of withdrawing IRA funds. That's because a 10% premature distribution tax applies to the taxable portion of IRA distributions taken prior to age 59½ (subject to certain exceptions).
Roth IRAs are subject to special rules. Your Roth IRA contributions are free from federal income tax when paid to you from your account and, if certain conditions are met (a "qualified distribution"), all investment earnings on these contributions are also tax free and penalty free when paid to you.
Designating a beneficiary for your IRA or retirement plan
If you have a traditional IRA or participate in an employer-sponsored retirement plan, carefully consider your choice of beneficiary. Your beneficiary will receive the money in your IRA or plan when you die. Your choice of beneficiary can determine (1) the tax deferral and distribution timing options available to your beneficiary and (2) whether the funds will be taxed in your estate for death tax purposes.
Because Roth IRAs are unique, the considerations regarding beneficiary designations for Roth IRAs are unique as well.
Inherited IRAs and employer-sponsored retirement plans
If you have inherited an IRA or retirement plan account, you need to be aware of the available options for taking or deferring distributions. With traditional IRAs and retirement plans, you usually have to pay income tax on the funds that you receive. Rather than simply taking all of the money from the IRA or plan at once (and paying tax on the lump-sum distribution), you may be able to defer and delay distributions from an inherited account (or plan) for a period of time, letting the dollars continue to grow tax deferred. The terms of the IRA or retirement plan will govern the distribution options available to you.
The information contained in this Higgins Capital communication is provided for information purposes and is not a solicitation or offer to buy or sell any securities or related financial instruments in any jurisdiction. Past performance does not guarantee future results.
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Ray Higgins San Diego broadridgeadvisor