Chapter 20

Options for Converting Retirement Assets into Income

Cessation of work is not accompanied by cessation of expenses.

—Cato the Elder

 

Retirement assets are typically considered “long-term, low-liquidity” investments—since mandatory distributions do not begin until age 70½, and voluntary distributions generally cannot be made before age 59½. Even then, voluntary distributions are subject to income tax, penalty, and excise tax. However, several options exist for converting your retirement assets into immediate cash.

Caution: Tapping into retirement funds is not something that should be done without careful consideration. Using these funds now means that asset growth will not be tax deferred. It also means the funds may not be available to you at retirement, and the money will no longer be protected from creditors, including the IRS. Consider the other new uses of assets discussed in chapters 19, 21, 22, and 23, and speak with an accountant or attorney before accessing these funds.

Section 1. Loans

Many retirement plans permit loans

• for any purpose;

• up to the amounts you have contributed (but not more than $50,000);

• subject to interest payments to the retirement plan, which in certain cases may be tax deductible (e.g., if you use the loan to purchase a home);

• that must be repaid quarterly within five years (unless the loan is used to purchase a home, in which case there is no legal limit on the repayment period);

• that are not subject to current tax unless you stop making repayments.

Loans versus withdrawals. Loans are more flexible than withdrawals because generally you do not have to demonstrate a purpose for a loan, whereas withdrawals are typically made for special purposes, such as hardship. Loans are also cheaper than withdrawals, since loans are subject to interest but not tax (if repaid on time), whereas withdrawals are subject to tax and tax penalties.

Loan options under employer-sponsored plans. Loan provisions vary among employer retirement plans, so check the specific terms of your plan regarding loan qualification, purpose, amount, and repayment. Your employer determines whether you qualify for a loan, typically by requiring you to demonstrate either that you have exhausted your personal financial resources or that alternate resources are not available to you. If you qualify for a loan from your retirement plan, you will be able to borrow an amount up to one-half of your vested account balance (typically up to $50,000).

If you have an outstanding loan balance against your employer retirement plan and are about to change jobs, you must repay the balance or you may be able to roll over the balance to your new employer’s plan. If you do not repay the balance, it will be treated as a withdrawal subject to income tax and the 10 percent tax penalty for early withdrawals.

Loans from ESOP plans are not permitted.

Loan options under individual-sponsored plans.

• Loans from qualified retirement plans such as pension, profit-sharing, and 401(k) plans are permitted unless you are a sole proprietor, partner, or shareholder of an S corporation.

• Loans from IRAs and SEP-IRAs are permitted, but with heavy penalties if the loan is outstanding for more than sixty days.

• Loans from annuities are not permitted.

Tip. If you are considering a loan for more than sixty days and have more than one retirement plan, borrow from your IRA last because of the possible taxes and penalties.

Section 2. Withdrawals

Withdrawals, also known as distributions, can be made from your pretax or after-tax contributions. Withdrawals from after-tax contributions can be made at any time, for any purpose, and only the tax-deferred earnings on these contributions are subject to tax. Withdrawals from pre-tax contributions can only be made in certain circumstances and are otherwise subject to income tax plus a 10 percent tax penalty for early withdrawals before age 59½. However, you may be eligible for special provisions that permit early distributions, sometimes on a tax-reduced basis.

Depending on the wording in the plan, anyone who is disabled within the Social Security definition can usually withdraw funds without penalty. Disability does not change the tax status of the money withdrawn.

Throughout the rest of this section, withdrawals refers to withdrawals of pretax contributions.

2.1 In General

Qualified plans. Withdrawals made from all qualified plans in the event of your disability, although subject to income tax, are exempt from the 10 percent tax penalty for early withdrawals. Disabled is defined under Tax Code section 72(m) as “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long, continued and indefinite duration.”

Employer retirement plan and your IRA. Withdrawals made before age 59½ from your employer retirement plan or IRA, in “substantially equal payments over your life expectancy, or the joint life expectancy of you and your spouse/named beneficiary,” are exempt from the 10 percent tax penalty for early withdrawals.

Pension and profit-sharing plans. Withdrawals from a pension or profit-sharing plan may also be available without a 10 percent tax penalty if the plan has an early-retirement provision of age fifty-five.

Tax-favored retirement accounts. Withdrawals from tax-favored retirement accounts are exempt from the 15 percent excise tax on annual withdrawals exceeding $155,000, for a three-year trial period beginning in 1997. People with serious health problems or critical financial needs should consider taking advantage of this three-year tax break, despite the prevailing 10 percent tax penalty for premature withdrawals.

Forward averaging. Withdrawals made at any age in the event of “total and permanent disability” are eligible for reduced income tax treatment under forward averaging rules. Using forward averaging rules, a lump-sum withdrawal will be treated for tax purposes as if it were made over five to ten years, resulting in a reduced rate of taxation. Note, you can only use forward averaging rules once. You cannot use forward averaging rules for IRA or SEP-IRA withdrawals. Five-year averaging will be phased out in 1999.

2.2 Options Under Employer-Sponsored Plans

Withdrawals from employer retirement plans can only be made for special purposes: to fund medical expenses, tuition costs, or a home purchase. These “hardship withdrawals” are generally subject to income tax and often a 10 percent tax penalty for early withdrawals. Your employer (using IRS guidelines) determines if you qualify for hardship withdrawals, which may include:

• Withdrawals to fund medical expenses exceeding 7.5 percent of your adjusted gross income are subject to income tax but exempt from the 10 percent tax penalty for early withdrawals (unlike other hardship withdrawals).

Tip. Your medical expenses must exceed 7.5 percent of your adjusted gross income for you to qualify for income tax deductions as well as penalty-free withdrawals from your retirement plan. The catch is that withdrawals from your retirement plan raise your adjusted gross income, in turn raising the threshold for allowable deductions. Therefore, try to consolidate your deductible medical expenses by accelerating or deferring expenses to years when you can exceed the 7.5 percent threshold.

• Withdrawals to fund college expenses for you, your spouse, or your children.

• Withdrawals to fund the downpayment for a home or to prevent a threatened mortgage foreclosure.

• Withdrawals of dividends earned in an ESOP are exempt from the 10 percent tax penalty for early withdrawals.

• If you are age fifty-five or older and about to leave your job, you can make a withdrawal from your employer retirement plan just before you roll over your retirement account to an IRA, and the withdrawal will be exempt from the 10 percent penalty for early withdrawals.

• Withdrawal of employer stock from your employer retirement plan: There are certain tax advantages associated with the employer stock in your plan, which you can apply when you withdraw the stock from your plan as you change jobs or retire. The three options for withdrawing the employer stock in your plan are to cash out, to take stock certificates, or to roll over to an IRA. Each option has different tax consequences. If your plan contains a considerable portion of employer stock that is significantly appreciable, taking stock certificates will maximize tax advantages, both for you and your heirs.

Information. You can obtain information about your plan from your employer or your union. You are legally entitled to this information.

2.3 Options Under Individual-Sponsored Plans

Withdrawals from IRAs can be made for any purpose (unlike withdrawals from employer retirement plans).

Three types of IRA withdrawals are eligible for tax exemptions:

• Withdrawals to fund medical expenses exceeding 7.5 percent of your adjusted gross income are exempt from the 10 percent tax penalty for early withdrawals.

• Temporary withdrawals made for sixty days are not subject to income tax or the 10 percent tax penalty for early withdrawals (unless the withdrawal is not reinvested within sixty days).

• Periodic withdrawals using the life expectancy method are exempt from the 10 percent tax penalty for early withdrawals. Allowable annual withdrawals are determined by dividing your IRA account balance by your life expectancy or the joint life expectancy of you and your spouse/beneficiary (as provided in IRS life expectancy schedules). You can begin this withdrawal method at any age, but must then make withdrawals annually thereafter.

Tip. By combining a home equity loan with the IRA life expectancy withdrawal method, you may be able to create a “tax-free” income stream to meet your contingency needs. For example, you could take out a home equity loan and use your IRA withdrawals to make the mortgage interest payments on your loan. Although your IRA withdrawals are subject to income tax, your mortgage interest payments are tax deductible, thereby creating a tax offset. Depending on your tax bracket and prevailing interest rates, the net result could be a “tax-free” source of emergency funding that might not otherwise be available to you.

Withdrawals from annuities are subject to income tax, plus the 10 percent tax penalty for early withdrawals, plus surrender charges (up to a 7 percent withdrawal penalty imposed by the plan sponsor). Generally, it is more expensive and difficult to make withdrawals from annuities than from other types of retirement plans—so if you think you might need to access your retirement funds early, don’t invest in an annuity.

Section 3. Transfers

The funds in your retirement plan are “portable” investments, meaning that typically you have the flexibility (within IRS and plan guidelines) wither to transfer these funds among different investment options under your plan, or to roll them over to different plans. Transfers and rollovers are generally not subject to tax, but they may be subject to certain fees, such as commissions or penalties, depending on the type of plan you have.

3.1 Options Under Employer-Sponsored Plans

If you change jobs or retire early, you can roll over your vested retirement funds either to your new employer’s plan or to an IRA. When rolling over your retirement funds, make sure not to take possession of the funds, or you will be subject to income tax. There is also a refundable 20 percent employer withholding tax and a potential 10 percent tax penalty for early withdrawals. There is one exception: if your employer retirement plan contains a considerable portion of employer stock that is significantly appreciable, you will forfeit certain tax advantages for yourself and your heirs if you roll over employer stock to an IRA.

Note that only pretax contributions are eligible for rollover, while after-tax contributions must be distributed subject to income tax on tax-deferred earnings.

3.2 Options Under Individual-Sponsored Plans

IRAs permit transfers among different investment options offered under the same plan, and rollovers among different plans. Transfers under the same plan may be made periodically (as per plan rules) and are not subject to tax or fees. Rollovers among different plans typically are permitted once per year and are not subject to taxes, but may be subject to certain fees.

Tip. When you open an IRA, make sure that the agreement you sign does not permit the trustee to automatically renew your IRA upon maturity without your prior approval.