Much of the focus on retirement planning centers around accumulating a nest egg large enough to help provide income to fund a comfortable retirement lifestyle. After all, there’s no sense worrying about how to get money from a retirement nest egg before the egg is ready to be "hatched." Or, is there?
Some complex tax laws prevent direct access to funds in retirement plans, such as employer-sponsored 401(k) plans and traditional Individual Retirement Accounts (IRAs), providing two potential tax traps for the unsuspecting. The trick, however, is to be able to crack these tax law "shells" without damaging the egg inside.
Tax Shell #1
The first "shell"—the too soon tax trap—comes into play if you withdraw money from your qualified retirement plan or IRA before age 591⁄2. Not only will any such withdrawals be taxed as regular income, but a 10% federal income tax penalty may also apply unless you qualify for an exception to the penalty.
For example, if you are over age 55 and are retiring or being terminated from your job, you can take a lump-sum distribution from a qualified plan, e.g., a 401(k), without penalty. This provision, however, does not apply to traditional IRAs. Keep in mind that such a distribution would still be subject to taxes at your ordinary income tax rate.
A second exception to the penalty is allowed when withdrawals are taken in "substantially equal periodic payments." There are three IRS-approved methods for determining these payments—the life expectancy distribution method, annuitization method, and the amortization method. Distributions using these methods must continue for at least five years or until age 591⁄2, whichever comes later.
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Tax Shell #2
The second "shell"—the too little tax trap—involves required minimum distributions (RMDs), which generally begin at age 701⁄2. Individuals (other than certain owner-employees still working beyond age 701⁄2) are allowed to delay distributions from their qualified plans and tax-sheltered annuities (TSAs)—but not from traditional IRAs. If you fail to withdraw the required amount, a 50% penalty is assessed on the shortfall. New rules finalized by the Internal Revenue Service (IRS) in 2002 simplify the calculation of RMDs and decrease the required distribution amounts. As always, there is no penalty for withdrawals in excess of the required minimum.
Before Your Eggs Are Hatched
Individuals who have accumulated substantial assets for retirement may want to calculate various income scenarios to help project future withdrawals from their retirement account(s). "Running the numbers" in advance may also help enable retirees to avoid potential tax traps as they prepare to hatch their retirement nest eggs. $