Before Tapping 401(k), Consider Long-Term Plans
Wall Street Journal - August 30, 2008
I've been told by an adviser that I could pull one amount out of my 401(k) to get me to age 59½ without the penalty. Is this correct? I'm retiring at the end of this year and will only be 58 in November.
--Dave Hamilton, Carrollton, Mo.
The short answer is: Yes, you can.
If you are at least 55 years old and have left your job, you can take at least one distribution from your 401(k) plan without penalty. And you may be able to take unlimited distributions. The federal tax code allows unlimited withdrawals without a penalty (again, if you have left your job after reaching age 55) -- but you will need to check with your 401(k) plan to see what it allows. The plan may have rules that limit the number of withdrawals or how often you can take them. You will have to pay income tax on any such withdrawals. (And we don't recommend draining your retirement savings early in retirement, either.)
When you turn 59½, you also have penalty-free access to any assets you might have in an individual retirement account. Again, you would owe income tax on any tax-deferred savings and earnings in an IRA.
One question that people should consider before withdrawing money from a 401(k): What are your long-term plans for the account? For example: Do you intend, at some point, to roll the assets into an IRA? If so, taking a partial distribution from your 401(k) today might mean you'll have to postpone an important tax break: net unrealized appreciation, or NUA.
If you have company stock in your 401(k), Uncle Sam allows you to withdraw those shares from your 401(k) at the same time you roll over the balance of your assets into an IRA. In doing so, you will have to pay tax on the original purchase price, or the cost basis, of the shares. But the gain on your shares while they were sitting in the 401(k) -- the net unrealized appreciation -- will be taxed (whenever you decide to sell the shares) at long-term capital-gains rates, which top out at 15%. In contrast, if you roll your company stock into an IRA, all withdrawals from that account are taxed at ordinary income rates -- as high as 35%.
The tricky part: Taking advantage of this tax break involves "triggering events," says Ed Slott, an IRA consultant in Rockville Centre, N.Y. For example, leaving your company is a triggering event, one that allows you to pursue the NUA strategy. But, if you take a partial distribution from your 401(k) (as in the case of this week's question), you have to wait for the next "triggering event" to kick in before you can take the NUA tax break. (Other triggering events are reaching age 59½, disability or death.) So, let's say a person leaves his company (a triggering event) at age 56 and takes a partial distribution from a 401(k). He would have to wait until age 59½ (or have a disability strike) before jumping on the NUA bandwagon.
Returning to the idea of penalty-free withdrawals: As with a 401(k), there is a way to withdraw funds from an IRA without penalty before age 59½ -- albeit one with strict rules. You have to take what the Internal Revenue Service calls "substantially equal" withdrawals for at least five years, or until you turn 59½, whichever period is longer. These scheduled payments are called 72(t) distributions, named for the section of the tax code that governs them.
In the case of this week's question, our reader probably wouldn't want to go this route; he would be on the hook until age 64. And 72(t) payments can be risky: If you take out too much money, or too little, in a given year, all your withdrawals up to that point could be hit with a 10% penalty and retroactive interest. (The penalty applies only to withdrawals before age 59½.) So, it's best to work with a financial adviser, accountant or IRA custodian experienced with 72(t) payments to set up your plan. (For more information online, visit 72t.net.)
The safest way to move 401(k) assets into an IRA, if you wind up deciding to do so, is with what's called a direct or "trustee-to-trustee" transfer. That means you move assets straight from the 401(k) to the IRA. If you withdraw the money yourself before redepositing it, make sure you complete the rollover within 60 days. If you take longer, the whole amount could be taxed. And according to Mr. Slott in New York, the IRS, which had been granting forgiveness for many rollover mistakes through favorable private-letter rulings in recent years, is getting tougher on such appeals.
See the full article...
401K Rollovers: Answers to common 401K Rollover questions at NewRetirement.com
Annuity Advice for Retirement: Evaluate and compare annuities at NewRetirement.com
Professional Financial Advisors: Tips for using a financial advisor for retirement planning.
About Reverse Mortgages: Learn all about reverse mortgages at NewRetirement.com
NewRetirement Retirement Calculator: Assess your retirement plan with the NewRetirement Retirement Calculator.