Putting Retirement Fund Money to Good Use
Financial advisers have been touting the idea of putting money aside in tax-deferred retirement accounts for years. Individuals are likely to need more than just company-sponsored pensions and Social Security to make it through their “golden years” in comfort, advisers maintain. And tax-favored savings can earn gratifying returns.
But what has received far less attention is what to do with these retirement fund riches when you’ve got to pull them out of your Keough, 401(k) or individual retirement account.
There are a number of reasons why this might happen. When an individual changes or loses a job, for example, his or her participation in company-sponsored 401(k) plans usually must end. While some companies allow former employees to maintain their accounts, others require them to shift their assets elsewhere.
Then too in the past several years, a number of smaller firms have terminated traditional pension plans and distributed the funds to their workers.
There are also a number of individuals who retire and find they don’t need all the money they’ve saved to handle monthly expenses. Yet some are forced by Internal Revenue Service rules to start withdrawing money from their IRA accounts anyway. Tax rules say individuals must start withdrawing--and paying tax on--tax-deferred retirement accounts when they reach the age of 70 1/2.
What should individuals do with retirement distributions?
Clearly, the answer depends on individual situations, but some generalities can be made, said Rod Lloyd-Williams, vice president of the savings and investment group at Wells Fargo Bank.
Most individuals will fall into one of two categories: older retirees who can take their funds without triggering special taxes; or those 59 and under, who will face stiff tax penalties if they don’t immediately put their retirement distributions back into a tax-deferred plan.
Those in the second category should have one primary goal. Roll those funds into an individual retirement account in a hurry. The type of IRA--whether it is invested in certificates of deposit or corporate stocks--is secondary, advisers note.
Why? If individuals fail to reinvest those funds in a tax-favored retirement account within 60 days, they must not only pay the tax on the proceeds, they must also pay a 10% penalty to the U.S. government and, possibly, a another penalty to the state. (California’s amounts to 2.5%)
What happens if you’ve been laid off from your job and fear you’ll need the money to live on? You should still roll it into a IRA account, Williams said. Then, if it turns out that you need some of the money, withdraw only the amount you need.
Here’s why: Consider two individuals looking for work after having been laid off. Each has $30,000 saved in a company 401(k) plan and they’ll both need to spend $8,000 of this amount to meet day-to-day living expenses until they secure new jobs.
Worker A takes his $30,000 check and puts it in the bank--but not in a IRA account. He pays 28% federal tax, 7% California tax and a 12.5% tax penalty. After spending the $8,000, he has $7,750 left over.
Worker B puts the $30,000 in a roll-over IRA, but then withdraws the $8,000 and an amount sufficient to pay the tax on these withdrawals. This worker is left with $14,762.
Turning to the category of older retirees, some will be prohibited from putting more assets into a tax-favored retirement account. At 70 1/2, they must start taking the money out of the accounts, whether they need it or not. The amount of money these individuals must withdraw is based on their life expectancy and the life expectancy of their beneficiary.
The reason? The accounts are tax-deferred, not tax-free. The IRS wants to make sure you pay the government your due before you die. If the amount withdrawn is less than the minimum amount the IRS requires the taxpayer to take in any given year, the IRS can assess an excise tax equal to 50% of the shortfall.
Assuming that this money is not needed for day-to-day living expenses, retirees have a wide array of options in how to invest it. But before considering those options, they need to consider their comfort with risk and the likelihood that they’ll need the money in the not-to-distant future.
If it is possible that this money will be needed within one or two years, the individual is probably best served to put it in relatively safe, liquid investments such as Treasury bills and insured certificates of deposit.
When the time frame is a little longer but the risk profile is still relatively low, investors can consider conservative mutual funds--perhaps those that invest in blue chip stocks or high-grade corporate bonds. Returns are more volatile in such funds, but the rewards are also often far richer.
If it is likely that the individual will not need the cash for their lifetime, they can take far greater risks. Or, if they have heirs, they might want to start giving money to their children. For those with significant estates, giving away up to $10,000 a year to each of their heirs essentially allows them to leave children and friends more money before triggering estate taxes, which can amount to 55%.
