In the past, a retiree typically received a monthly pension check and Social Security benefits. Now, it’s not uncommon for a retiree to have a pension plan, a couple of 401(k) plans, some individual retirement accounts (IRAs), personal savings, possibly some deferred compensation, and maybe an annuity. Deciding how to handle all of those different income sources in the most advantageous manner is a daunting task. In many cases, decisions regarding pension plans are irrevocable, so proper choices are imperative. Before making those decisions, consider the following:
Prepare a list of all of your retirement assets, by type of plan. Indicate the expected monthly income as well as the earliest and latest date you can start taking benefits. Review the payment options available to see if some assets should be used before others. For instance, defined-benefit plans and deferred compensation plans generally require you to take benefits when you retire, whether you want the money or not. Other plans, such as 401(k)s and IRAs, allow you to start withdrawals between the ages of 59 1/2 and 70 1/2, providing flexibility regarding the amount withdrawn. Thus, if you can, it is typically advantageous to either leave that money in the plan or roll it over to an IRA to grow tax deferred until a later date. You must begin taking minimum distributions from traditional IRAs (not Roth IRAs), 401(k) plans (unless you are still working), and other qualified plans by the time you are 70 1/2.
Decide whether you want to take a lump-sum distribution or receive an annuity. This option is generally offered with 401(k) plans, profit-sharing plans, and some defined-contribution plans. Your decision should be based on the income tax ramifications of the different options, your personal needs, and your financial ability to handle the money.
If you opt for an annuity, you must decide among various payment options, including life only, which pays you a certain amount until your death; joint and survivor, which will also pay a certain amount to your spouse after your death; and life and period certain, which pays a certain amount for your life or a specific time period, whichever is longer. Your payments are generally taxed as ordinary income when received.
You may like the peace of mind that comes with annuities, since you are assured of a monthly income without having to worry about investment decisions. However, annuity amounts are typically fixed, so inflation can seriously erode the purchasing power of this income over the years.
A lump-sum distribution gives you the opportunity to invest your retirement funds. Thus, you receive the rewards of smart investment decisions, but you can also suffer from poor decisions. Since you own the funds, proceeds can be left to your heirs after death.
The tax treatment of a lump-sum distribution depends on how you handle the distribution. The least favorable alternative is to include all the proceeds in your taxable income in the current year, subjecting the proceeds to your top tax rate, and possibly the 10% tax penalty if you are under age 59 1/2.
As an alternative, any portion of your account balance in a qualified plan can be rolled over into an IRA within 60 days. This rollover defers the tax on the distribution and allows it to grow tax deferred until withdrawn. Keep in mind that if you take possession of the funds, your employer must withhold 20% of the proceeds, even if you plan to roll over the entire balance. You can avoid this provision by having your employer directly transfer the distribution to your IRA. If you are between the ages of 59 1/2 and 70 1/2, you can access the funds as you need them, penalty free, paying ordinary income taxes only as you withdraw funds.
Determine how to withdraw money from your plans. After going through this analysis, you can decide when to start taking distributions. These decisions will take into account your life expectancy, your tax situation, your current income needs, the expected inflation rate, and your expected rate of return on retirement assets. The calculations can quickly become very complex if you need to evaluate several different plans under several different payment scenarios. These calculations are so important for your retirement, consider seeking the help of a financial advisor to guide you through the process.