The Basic Rules of Retirement Plans
The rules around retirement plans are much too complicated. Back in the day, your parents or grandparents may have worked for the same company and upon retirement received a pension payable until they and their spouse had both passed away. Few, other than most public employees, have this benefit today. Instead, you probably have a 401(k) or 403(b) plan which upon retirement you may convert to an individual retirement account (IRA). While your employer (or employers over the years) may contribute to your plan, how much you save, how you invest your savings and how much and when you withdraw your nest egg is mostly up to you. Unlike a pension which will last you the rest of your life no matter how long you live, your decisions around your retirement plan can be crucial since you could be left high and dry if, for example, you run out of funds at age 85 but live to 95.
Fortunately, the rules for the most part are the same for 401(k) and 403(b) and IRAs, so we do not have to distinguish between them. They are somewhat different for Roth IRAs. To give you my two-cents worth, while Roth IRAs can be advantageous for some taxpayers, they should never have been created. They further complicate the financial life of taxpayers. Few people use them, though many feel they need to consider them. And some wealthy people have used them to avoid taxes on huge investment gains in a way that is unavailable to the average taxpayer.
The main benefit of retirement plans is that you are not taxed on earnings you divert to the retirement plan, instead you are taxed as you withdraw the funds, presumably in retirement. While the funds are invested they grow free of capital gains and income taxes. When you withdraw funds during retirement likely you will be in a lower tax bracket than when you were working and saving up. In addition, over time your retirement investments should grow faster than your other investments since you will have the opportunity reinvest all of your investment earnings. Here’s how that works: If your IRA earns $1,000 in interest and dividends this year, you can reinvest all of it for further earnings next year. In contrast, if your non-retirement plan account earns $1,000 this year, you’ll have to pay taxes on those earnings. If, for instance, a third is taxed, you’ll only have $667 to invest next year. If you earn a return of 5 percent, you will earn $50 on the $1,000 in your retirement account but only $33 on your after-tax investments. Over many years and decades this difference can add up.
Another benefit of tax-deferred retirement plans is that they permit more flexible investing. With your non-IRA investments, if you wanted to liquidate some of your stock investments because you thought the market was over-valued, you would have to pay taxes on any capital gains earned in the sale of the stock. This would not be the case on stock sold within a retirement plan. In contrast, a downside of tax-deferred retirement plans is that when you ultimately withdraw funds you’ll pay taxes on those funds as ordinary income rather than at the lower capital gains tax rate.
Since the idea of retirement plans is that you will use the funds to finance your retirement, the rules penalize you both for early withdrawal, before retirement, and for not withdrawing funds during retirement. With some exceptions, if you withdraw retirement plan funds before age 59 ½, you must pay a 10% excise tax on the amount withdrawn in addition to the withdrawal being treated as taxable income. On the other end, you must begin taking withdrawals by April 1st of the year following the calendar year in which you turn 70 ½. The amount you must withdraw is figured by dividing the total of all of your retirement accounts on December 31st of the prior year by your life expectancy as provided on the IRS tables found here. There’s one table for single individuals and another you use if you are married and your spouse is more than 10 years younger than you and is the sole beneficiary of your retirement plan.
If, for instance, you were still 70 years old as of the end of the prior year, the divisor is 17. If you had $350,000 in your retirement accounts as of December 31st, your minimum distribution would be $20,588 ($350,000 ÷ 17 = $20,588). The divisor goes down along with your life expectancy each year which means that the percentage you must withdraw goes up. For instance, if you were 85 years old at the end of the prior year, your divisor would be 7.6, meaning that if you still had $350,000 in retirement funds you would have to take out a minimum distribution of at least $46,053 ($350,000 ÷ 7.6 = $46,053). If you are 70 and your spouse is 50, then the divisor is 35.1, so the required distribution would be just under $10,000 ($350,000 ÷ 35.1 = $9,9715).
Don’t miss your required minimum distribution. The penalty is a whopping 50% of what you should have withdrawn. It’s possible to ask the IRS for a waiver if this occurred due to “a reasonable error,” but don’t put yourself in a position of having to ask for forgiveness. Make the calculation and make the withdrawal. Of course, you can always take out more, but then you would lose the tax benefits of continuing to invest the funds tax free and may be at risk of running out funds before you run out of life.