By Sam Maness

Pensions are quickly becoming a thing of the past, and Social Security won't cover the bills for most retirees. Most of us are relying more and more on investment savings -- often held within retirement accounts -- to fund the golden years. It is not uncommon for investors to have six and seven-figure nest eggs within these accounts, making it more important than ever to properly manage the assets and plan appropriately for the future.

The popular retirement plans are IRA, 401(k), 403(b), and 457(b). These offer great tax benefits to investors. Most qualified retirement plans and traditional IRAs allow you to invest your money on a pre-tax basis, let it grow during your working years, and delay the tax bill until you take withdrawals in retirement. Roth IRAs and Roth 401(k)s are funded with after-tax dollars -- even if the account doubles or triples over time, the entire balance can be withdrawn tax-free in retirement.

These are great ways to save for the future but it is important to understand the rules and restrictions as well. With a few noted exceptions, the IRS hits you with a 10% penalty for early withdrawals. And they won't let you hide from the tax collector indefinitely. Most accounts require you to take distributions and start paying taxes at age 70 ½. This outline explores the mechanics to help get you started.

When can you take withdrawals

You can start withdrawing money from qualified retirement plans and IRAs starting at age 59 ½. Before that magic number, distributions are subject to a 10% early withdrawal penalty, with several exceptions to the rule. See IRC § 72(t). These include exceptions for:

  • death or disability
  • rollover to another qualified plan
  • series of substantially equal periodic payments
  • unreimbursed medical expenses in excess of 10% of your adjusted gross income
  • age 55 with separation from service
  • distributions pursuant to a divorce order (Qualified Plans only)
  • health insurance premiums (IRAs only)
  • higher education expenses (IRAs only)
  • first-time home purchase (IRAs only)

A comprehensive chart of the IRS exceptions is available here. Look carefully before taking withdrawals - as you can see, some of these exceptions apply only to IRAs and others apply only to Qualified Plans (401k, 403b, etc.). Two account types receive unique treatment under the law:

Non-Qualified 457(b) Plan distributions are not subject to the 10% early withdrawal penalty, except for distributions attributable to rollovers from another type of plan or IRA. These plans are generally available to governmental employees, including educators, and select non-governmental employees. Your 457 may have plan-specific rules for withdrawals, so work with an advisor to better understand your options.

Roth IRAs and Roth 401(k) Accounts distribute both contributions and investment earnings tax-free, but early withdrawals are still subject to the same penalties and exceptions provided above. Roth IRA accounts must also satisfy one of two five-year "holding" rules, depending on whether funds were contributed directly by the account owner or converted from a traditional pre-tax retirement account. Any Roth dollars within a 401(k) or 403(b) plan must satisfy the rule separately from Roth IRA accounts you own.

    Contributions: earnings only receive tax-free treatment if the initial contribution took place five or more tax years* ago.

    Conversions: principal and earnings only receive tax-free treatment if the conversion took place five or more tax years ago.

    * if you make your first contribution in 2018, earnings can be withdrawn tax-free starting in 2023.

    When must you take withdrawals

    Starting in the year you reach age 70 ½, account owners must withdraw money from qualified retirement plans in the form of a Required Minimum Distribution ("RMD"). See IRC § 401(a)(9). In the first year, you can delay your withdrawal until April 1st of the following year, but after that you will have a December 31st deadline. If you anticipate lower income in the year after reaching age 70 ½, it may be worth delaying until after 12/31 to move income to the new tax year. See IRC § 401(a)(9). You can also delay withdrawals for:

      Roth IRA accounts, indefinitely - you're never required to take withdrawals.

      Withdrawals from a company plan if you're still employed. This applies to all 403(b) and most private 401(k) plans.

      The RMD is determined by dividing the account value on December 31st of the prior year by a "life expectancy factor" - a percentage amount provided within the IRS Uniform Life Tables. At age 70 the factor is around 27, so a $100,000 portfolio would require a first-year withdrawal of about $3,704, and it goes up every year from there. Different tables apply for beneficiaries and for account owners with a younger spouse (ten or more years). But don't worry - you won't have to learn these tables by heart - the plan or investment company holding your account generally makes the calculation and provides you with the RMD amount each year.

      Taking withdrawals before the annual deadline is critical. The IRS issues a 50% excise tax for any missed RMD amount - meaning you pay a $5,000 tax for missing a $10,000 RMD. If you find yourself in this situation, withdraw the missed RMD right away. Many taxpayers have successfully requested a waiver of the penalty by filing Form 5329 and attaching a letter of explanation. We recommend working with your advisor, attorney, or accountant if you miss your RMD.

      What if you have Multiple Plans?

      First, keep in mind that spouses can't pool RMDs. These are individual accounts, so you have to look at your plans separately. If you have multiple accounts, for example, you might consider tax-free rollovers - moving assets from various 401(k) and other retirement plan accounts to a consolidated IRA. This makes for an easier RMD withdrawal process, simplifies your designated beneficiary elections for estate planning, and could provide more efficient and organized portfolio management.

      If you own multiple plans of the same type, the following rules apply:

      IRAs:

      • you can pool RMDs and withdraw the entire amount from a single account.

      403(b)s:

      • you can pool RMDs and withdraw the entire amount from a single account.

      401(k)s:

      • you must take RMDs separately from each account.

      In Closing

      Retirement assets come along with some additional rules & restrictions, and this added complexity may seem daunting at times. The ability to increase your net worth and your retirement portfolio using tax-deferred investment growth generally makes it well worth the extra effort required to properly manage these accounts. I encourage you to consult with a professional advisor if you have questions about your investment accounts - and wish you a happy, healthy, and meaningful retirement. Thanks for reading.

      Sam Maness is a financial advisor with McLaren Wealth Strategies at 315 E. Eisenhower Ave, Suite 301, Ann Arbor, Michigan 48108. You can contact the McLaren team at mclarenwealth@raymondjames.com or 1-866-944-7556.

      Opinions expressed are those of the author and not necessarily those of Raymond James Financial, Services. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Links are provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed web sites or their respective sponsors.

      Securities offered through Raymond James Financial, Inc. Member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. McLaren Wealth Strategies is not a registered broker/dealer and is independent of Raymond James Financial Services, Inc..