Mechanics of Making Withdrawals
KEY TAKEAWAYS:
When creating an income stream from your nest egg, IRAs offer the most convenience compared to employer retirement plans, such as 401(k)s.
You can set up electronic funds transfers (EFT) with your IRA and after-tax brokerage accounts in a way that feels awfully similar to the paycheck you received while working.
The decision between keeping your 401(k) or 403(b) plan with your employer versus rolling it over to an IRA includes a myriad of factors, which will depend on what you value and your set of circumstances.
Of the four ways to move funds from your retirement plan to an IRA, direct rollovers and direct transfers are the most preferred choices because of how seamlessly the transfer is handled.
Mechanics of Making Withdrawals is entry #6 in our Retirement Income Series. This article will focus on how to get money out of your nest egg. In addition, we will provide you with the knowledge you need to properly plan, organize, and structure your withdrawals so that you have an easy process to follow.
We will begin by overviewing the three main account structures that you can make withdrawals from, which are IRAs, after-tax brokerage accounts, and employer plans (401(k), 403(b), TSP, 457). Next, we will examine your distribution options when leaving an employer and whether you should rollover your funds to an IRA or leave the money with your employer. After that, we will go over your options when you reach 59 ½ and are still working. Finally, we will provide the steps you need to take when moving your employer plan to an IRA so that you don’t cost yourself thousands of dollars.
First, let’s take a close-up view of what it looks like to take a withdrawal from each of the three types of accounts mentioned above.
IRAs
Individual retirement accounts (IRAs) offer the most ease and convenience of the three account types because of their flexibility, ability to pay taxes to the IRS at the time of distribution and make the deposit feel like you are getting a paycheck.
With IRAs, you can take money out on a one-time basis, or you can take it as a recurring amount on a monthly, quarterly, or annual basis. In other words, you have the flexibility to take both ad hoc withdrawals and automate your withdrawals.
One of the most convenient parts is having income taxes withheld from your withdrawals as a fixed dollar amount or specified percentage. Your withheld taxes are sent directly to the IRS at the time of withdrawal, similar to how your taxes are withheld from a paycheck.
In that same vein, you can establish an electronic funds transfer (EFT) between your investment account and bank account for direct deposits. For those uncomfortable with the EFT option, you may also receive a check in the mail.
After-tax Brokerage
Withdrawals from an after-tax brokerage account are nearly identical to IRAs in terms of how they operate. The only difference is that you cannot withhold taxes when a withdrawal is processed. Instead, you need to go to the IRS’ website at www.irs.gov and make a one-time payment for the estimated taxes you owe related to the capital gains generated. You might also consider mapping out what your annual dividends and interest payments will be so that you pay the taxes generated from those income sources in advance.
Employer Plans
Processing withdrawals from 401(k), 403(b), TSP, and 457 plans differ from the first two options we covered. Unfortunately, taking money out of employer plans is more cumbersome, as some employer plans may require signing a paper form to process a partial withdrawal. Even if you can process the withdrawal online, you must manually enter your request each time you want money. Meaning you are unable to automate your withdrawals.
When partial withdrawals are permitted, the employer plan typically requires a minimum of 20% for federal income taxes to be withheld. On top of that, your employer may restrict your withdrawal frequency, limit the amount you can take out, or require the entire account to be liquidated in order to access your money. Another potential nuisance is certain plans charge you a fee to process your withdrawal
You might ask yourself, “Why do employer plans make accessing MY MONEY such a hassle?” The simple answer is that your employer doesn’t want to act as your bank ATM because it is too costly and time-consuming for them to administer. It’s almost as if they encourage you to move your money elsewhere, which is why the most common solution to this problem is performing a direct rollover of your employer plan to an IRA. The nice thing about this type of transfer is that you don’t pay taxes if you execute each step of the rollover process properly.
We will cover more specifics about rollovers in a moment. Before we do that, let’s consider the different distribution options available when you leave your employer.
Distribution Options When You Leave an Employer
Upon retiring or terminating your employment, you have five options to consider with your retirement plan:
1) Take a Lump-Sum Distribution
A lump-sum distribution is the least desirable option, especially if your retirement plan has a significant balance. The result of a lump-sum distribution is that the amount received is fully taxable, and it may be subject to a 10% IRS penalty if you are under 55.
In other words, if you have $1M in your 401(k) plan, and you decide you are going to take a distribution because you don’t like investing in the market and want to buy your dream home on the beach, that is also going to be an income generating property via Airbnb – the unfortunate reality is that you only net $800k. So, instead of buying that $1M home with cash, you will need to find more financing or a less dreamy home. The more significant issue is that your $1M distribution is included in your taxable income – under current marginal tax rates, you’re now in the highest tax bracket at 37%. This means you may owe even more in taxes than the $200k that was withheld when you made your withdrawal and will have to settle up with the IRS at tax time.
2) Leave the Funds with Your Former Employer Plan
If the plan allows you to, you may leave your retirement with your former employer. It’s common to keep your money with your former employer if you are comfortable with the plan. Sometimes the path of least resistance makes life easier. However, if you have multiple retirement plans scattered around, managing your retirement could grow increasingly more difficult as you approach the age you are required to take minimum distributions (RMDs). Aside from the RMD issue, there are additional considerations we will get into in a bit.
3) Transfer Your Nest Egg into a New Employer Plan
If the thought of having multiple retirement plans scattered around sounds like a pain, and you prefer to consolidate the money with your new employer, then transferring your old plan to your new employer plan is an option you may want to do. Unfortunately, the problem with this approach is that the funds you rolled over may become less liquid if the plan has restrictions that limit accessing your money while you are employed.
4) Rollover Your Retirement Plan to a Traditional IRA
Another way to consolidate your retirement plans is by rolling over your funds to a traditional IRA. The benefit of doing so is that you have all your pre-tax retirement money housed in one spot, and you maintain a higher degree of liquidity. Additionally, your funds remain tax-sheltered while you leave the money in the IRA.
5) Rollover Your Retirement Plan to a Roth IRA
If you have a Roth retirement plan through your employer, transferring your funds to a Roth IRA is a non-taxable event. However, if the source of funds is from a traditional retirement plan, then the amount rolled into a Roth IRA is fully taxable. However, because the amount moved to the Roth is considered a Roth conversion, those funds are not subject to the 10% IRS penalty.
Should You Leave Your Money in Your Employer Plan or Roll It Over to an IRA?
When we eliminate lump-sum withdrawals from our consideration because of the tax implications, your distribution options can ultimately be boiled down into two big-picture choices – employer plans and IRAs. Deciding which account type is better for you will depend on your situation and goals and how well the other features available to you with each account meet your objectives.
The table below provides a side-by-side comparison of the benefits and drawbacks of choosing an Employer Plan versus a Traditional IRA. Note that the points listed in RED are the disadvantages compared to the other account alternative, and the text listed in BLUE are the positive features compared to the other account type.
Options for Employees Over 59 ½ But Still Working
After reviewing the pros and cons of rolling over an IRA, you might wonder what you can do if you are still working but want to rollover your employer plan to an IRA because you deem it the better option. As long as you are over the age of 59 ½, most employer plans will allow what’s called an in-service rollover to an IRA. An in-service rollover is a tax-free transfer of your assets from the employer plan to your personal IRA while continuing to allow you to contribute to your employer plan and preserve your company match.
To determine if your employer retirement plan allows in-service rollovers, you must review the plan rules, which are outlined in the Summary Plan Description (SPD) – this document can usually be found within the menu of options listed within your online portal. Sometimes you may need to contact your Human Resources department if it’s not readily available in a digital format.
When Moving Your Employer Plan to an IRA
When transitioning your nest egg dollars from an employer plan to an IRA, handling this type of transfer with care is critical because the financial consequences of messing it up can feel like a swift kick in the pants. With that said, there are two methods you should avoid: 1) taking an outright distribution and 2) indirect rollovers. On the other hand, the two options that you should consider utilizing are: 1) direct rollovers and 2) direct transfers. First, we’ll review what can go wrong, and then we will cover the right way to move your retirement funds to an IRA.
Distributions
The result of taking an outright distribution is that your retirement plan must withhold at least 20% for Federal taxes (some states might require withholding state income taxes as well). Under most circumstances, taking a lump sum should be a last-resort withdrawal strategy when desperate times call for desperate measures. Or consider taking the lump sum when you have an insignificant balance, and the tax impact is unsubstantial.
Indirect Rollovers
Moving your employer retirement funds via an indirect rollover is generally a no-no because the same issue with paying Federal income taxes can arise. An indirect rollover occurs when you get a check made payable to YOU, you CASH in that check, deposit it at your bank and then put all those funds BACK INTO YOUR IRA. Everything works out great if you complete the rollover within 60 days – no taxes. However, if you redeposit your retirement funds into your IRA on day 61, Uncle Sam will stick his hand out and collect. So, if the 60-day deadline cannot be CONFIDENTLY met, you should avoid this method of transfer. Keep in mind that the employer plan likely withheld 20% for mandatory tax withholding, so in order to fully rollover your account and avoid tax consequences, you’ll have to come up with that 20% in cash to supplement the check you received. Everything will even out when you do your taxes, but until then the IRS will hold on to that mandatory 20% that was withheld.
Direct Rollover
It’s funny how one word can make a huge difference – direct instead of indirect. A direct rollover means that the employer plan writes a check made out to your IRA custodian for the benefit of you, the owner of the IRA. The check is mailed to you or the custodian (e.g., Fidelity, Charles Schwab). In situations when the check is mailed to your home address, it is best practice to send those funds via FedEx or UPS to your custodian so that you don’t risk the check getting lost or stolen. The estimated $25 shipping fee is worth protecting the nest egg you worked so hard to build for all those years.
Direct Transfer
A direct transfer is the best option for moving your retirement plan to an IRA whenever it is available because the funds are wired directly from your plan to the IRA. The service rep on the phone takes down your account number and custodian information and mashes a couple of buttons... and voila, your money magically appears in your IRA within a few business days. You will still receive confirmation of the transfer via email or mail, but it’s also good to ask for a confirmation number before you disconnect. Ultimately, choosing this path prevents having to follow multiple steps, which is a common issue with the other options.
Coming Up Next in our Retirement Income Series
With a better grasp of how to access your nest egg, you are ready to sit back and live a more relaxing retirement. But wait a minute… ‘didn’t you mention the IRS requires me to withdraw money from my IRA at a certain age?’ Yes, unfortunately, there comes a time when the IRS requires you to take out a certain percentage of funds from your IRA on an annual basis – commonly referred to as Required Minimum Distributions, which is entry #7 in our Retirement Income Series.
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