Plan ahead to avoid tax traps in using retirement funds
By Mary Beth Franklin
Maturity News Service
When it comes to retirement planning, the first thing most people worry about is
putting enough money away to finance a comfortable future.
But you also have to plan how to get your money out of your nest egg. Otherwise, you
may fall into one of three costly tax traps: withdrawing too soon, too late or too much.
Qualified retirement plans, which include individual retirement accounts (IRAs), Keogh
plans, SEP-IRAs and 401(k) plans offer the advantage of tax-deferred growth. Without taxes
chipping away at your earnings, your investments can grow faster.
But since the government gives you a tax deduction on the money earned by your
investments and usually on the money you contribute to your retirement plan, it levies
taxes on the money when you take it out.
"Developing a strategy for getting your money out of your retirement plan is as
important as putting it in", said Peter M. Quinn, a supervisor in the pension
department of the Guardian Life Insurance Company of America. "You need a strategy to
defer these taxes as long as possible."
Here's a look at the possible tax pitfalls associated with retirement plan withdrawals
and suggestions on how to avoid them:
Withdrawing too soon.
If you take money out of a qualified retirement plan or IRA before you turn 59-1/2,
you'll probably pay a 10 percent penalty on the amount you withdrew, in addition to
regular income taxes.
Obviously, the easiest way to avoid this trap is to leave the money alone until you
turn 59-1/2. But a financial crisis may force you to go into your savings early.
Luckily, there are some exceptions to the rule that may allow you to avoid the tax
If you are 55 and are retiring or being terminated from your job, you can withdraw your
qualified plan benefit in a lump sum without penalty.
This provision does not apply to IRA distributions, but there are ways to take money
out of your IRA early without tax penalty.
You can withdraw funds in roughly equal periodic payments based on your life expectancy
or the joint life expectancy of you and your beneficiary. (The IRS has tables telling you
how long that is.) Withdrawals must continue for at least five years.
Or you can take an early withdrawal of IRA funds without tax penalty if the money is
used to pay for catastrophic medical expenses - that is, medical costs exceeding 7.5
percent of your adjusted gross income.
IRA funds can also be withdrawn early without penalty upon the death or disability of
the plan owner or as part of a divorce court order.
Withdrawing too little.
Most financial planners advise you to wait as long as possible before with
drawing funds from tax-deferred accounts because the funds grow faster that way.
That's fine if you can get by without extra income. But at age 70-1/2, you must begin
making at least minimum withdrawals, based on the life expectancy tables, even if you're
still working. Otherwise, you will pay a 50 percent penalty on the minimum amount you
failed to withdraw.
The first withdrawal must be completed by April 1 of the year after you turn 70-1/2.
Pay attention to the calendar and make those minimum withdrawals or Uncle Sam will take
half of what you should have.
Withdrawing too much.
This sounds like a problem we all should have, but people who diligently sock away
funds in their retirement plans during their entire working life can build up a good-sized
account by retirement. It's not impossible to amass $1 million or more even on a
The rub is that when you reach 70-1/2 and have to start withdrawing funds, your minimum
might be over $150,000 a year. If so, or if you have a lump sum withdrawal of over
$750,000, you'll pay an extra 15 percent tax on any amount over those ceilings.
The government lumps together all your plans in calculating whether you are subject to
this so-called "success tax".
Even though it's advantageous for most people to delay withdrawals from their
retirement plans as long as possible in order to defer taxes, those with substantial
retirement savings should consider withdrawing money each year before they are required in
order to reduce the plan's balance. Income taxes will be due on withdrawals but you may
avoid the 15 percent excise tax on excess accumulations.
If you are in the "success tax" bracket, get some professional advice and
start planning early for shifting funds out of your retirement account with the minimum
One strategy is to use your plan withdrawals to set up an irrevocable trust for the
benefit of your children or grandchildren. The trust can purchase a life insurance policy
that will provide for your heirs while removing the funds from your estate and potential