Are you ready for the next phase of life? One that leaves the daily grind behind? If you're nearing retirement age, you've been saving for a long time, and now you're getting close to the point where you can start taking distributions (finally).
Let's review everything you need to know about taking a distribution from an IRA or 401(k).
Options For IRA or 401(k) Distributions
When you receive a distribution from a 401k or IRA you should weigh the following tax options:
- You can report the distribution as ordinary income. Anyone who receives a distribution from a 401k or IRA can choose to pay ordinary income tax on the distribution—unless you have a Roth IRA.
- You can roll over the distribution to a traditional IRA or other retirement plan. Rather than paying ordinary income tax on your retirement plan distribution, you can roll over into a traditional IRA or self-directed IRA, also known as a SDIRA or solo IRA. If the funds are distributed directly to you, you have 60 days to deposit them into another plan or an IRA. The portion that is rolled over will continue to be tax deferred and will be subject to all the rules of the new plan or IRA. See our article, How to Take Distributions From Your Self-Directed IRA for more information.
- You can take advantage of forward averaging. You are eligible to use forward averaging if you satisfy all of the following:
- You were born before 1936.
- You have not used ten-year averaging on any distribution since 1986.
- You participated in your plan for at least five years.
What Happens When You Take Money Out of Your IRA or 401(k)?
You'd think this would be a no brainer, wouldn't you? You saved up for retirement, now it's time to start receiving it. But it's never simple when the IRS is involved. When you take money out of your IRA or 401K, the following income tax rules apply.
- Your distributions are taxable immediately. All distributions will be taxed in the year they come out of the plan. There is an exception when you roll over your distribution into another retirement plan or a traditional IRA or when your employer transfers the distribution directly into another plan or traditional IRA.
- Your basis is not taxable. If you made contributions to an IRA or 401k and you were not permitted to take a tax deduction on your tax return, then you will have what is called "basis" for tax purposes. You will not have to pay taxes on those amounts a second time when you take the money out of your plan. However, if you have a traditional IRA every time you take a distribution, part of it is taxable and part of it is not.
- You don't have to withdraw cash. When you take a distribution from an IRA, you may choose the assets you want to withdraw - you are not required to take cash.
- You may not claim a loss. You may not claim a loss on your tax return for any loss incurred inside your IRA or 401k. Instead, you pay tax on each distribution based on the cash value or the fair market value of the property on the date it is distributed from the plan.
How Are Distributions From a Traditional IRA Taxed?
Distributions from a traditional IRA are taxed as ordinary income, but if you made non-deductible contributions, not all of the distributions will be taxable.
Internal Revenue Code Section 72(t) imposes a tax equal to 10 percent of certain early distributions from IRAs (exclusive of portions considered a return of non-deductible contributions).
The 10% tax, which must be paid in addition to the regular income tax on the distribution, applies to all IRA distributions except the following:
- Qualified first time homebuyer distributions.
- Distributions to the estate or beneficiary of an IRA contributor after the contributor's death.
- Distributions not exceeding the deduction allowed to the taxpayer for the year for medical expenses.
- Distributions to alternate payees under qualified domestic relations orders.
- Distributions after the owner's “separation from employment” not exceeding amounts he or she pays for health insurance (assuming the owner has received 12 weeks of unemployment compensation and not been employed for a period of more than 60 days since receiving unemployment compensation.)
- Distributions to an IRA contributor after age 59 1/2 or on account of his or her disability.
- Distributions not in excess of the owner's “qualified higher education expenses” for the taxable year.
- A series of substantially equal periodic payments, regardless of the taxpayer's age when they begin.
- A distribution on account of the IRS. (Levies, etc.)
Options For Receiving Distributions Before Retiring
The current retirement plan rules discourage taking distributions before retirement. The following are the options you have when receiving a distribution prior to retirement:
- Pay ordinary income tax. (Unless you have a Roth, but there will be some sort of tax still.)
- Roll over your distribution: If you have not yet reached age 59 and 1/2 and you receive a distribution from a qualified plan, you can roll over the distribution into a traditional IRA or another retirement plan to continue deferring tax.
As I mentioned above, you can also choose to do forward averaging. But your best bet is to just wait until you reach retirement age.