Basics of Retirement Tax Planning

This time of year I see a lot of clients doing a little tax planning. The issue most asked about is taking money from a retirement plan. They want to know how much their tax will be if they take a withdrawal. Unfortunately, there is no easy answer. It all depends on the client‘s situation.

Anytime a taxpayer takes money out of their IRA or 401K (or any of the qualified pension plans) there is a good chance that the distribution is taxable. Some are closing out a pension plan from a past employer. Others are retiring and are trying to figure out what to do with their pension plan.

For clients who have a pension plan with a previous employer, my question is if they can just roll it over into their current plan or a traditional IRA. Actually, the question should be if they can leave to money alone to do the rollover. Most plans are set up to do a trustee to trustee rollover. That way there is no taxable distribution. The taxpayer will get a 1099R showing a rollover with $0.00 in the taxable amount. This way they save themselves the tax and possible early withdrawal penalty on what they move. However, most clients want that money in their hands now. In that case, the pension plan will generally withhold 20% Federal withholding and a set percentage for the state. The big mistake most taxpayers make is thinking that all their taxes are paid on the distribution. Of the 20% Federal withholding, 10% could be for the early withdrawal penalty. That only leaves 10% for taxes. The actual amount for the tax will depend on their marginal tax rate. If the taxpayer is in the 15% tax bracket, their tax on the distribution will be 15%. The withholding won’t cover all the penalty and tax. That’s why they need to talk to their tax pro with all their income specifics to get a good tax estimate.

The same considerations need to be made when the taxpayer is retiring. Many plans allow the taxpayer to take a lump sum distribution or spread the payments over time, or both. A lump sum distribution will put all the taxable income from the withdrawal in to one year. There probably won’t be an early withdrawal penalty just regular tax. But a taxpayer could get a big surprise if the lump sum moves them into a higher tax bracket. And it’s not just the lump sum affecting their taxes. Wages before retirement, payouts of retirement or severance packages, month pension payments, and Social Security benefits need to be considered too. The year of retirement can be a high income and high tax year. Taking the retirement as an annuity could save the client taxes in the long run but it will depend on planning for all income.

Anytime you consider taking money out of a retirement plan you should plan on talking to a tax pro. There is a lot we can help with; explaining the basic taxation of the withdrawal, look at your income and estimate the tax, help with a W-4P, explain IRAs so you know your rollover options, and bring up factors you might not have considered.

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Comments

[tax preparation]

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[Angelina Marshall]

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[Mike M.]

Nice article. There are some few exceptions to the 10% penalty on early distributions from an IRA such as certain qualified medical expenses. The penaly in addition to the tax rate on early ditributions may make it vary costly to do early withdrawals as the article states. --Mike M. http://www.murraycavanaugh.com/

[Tax Preparation Virginia]

thanks for the insight. the points you discussed over here are really beneficial for retirees, and just tiny planning can go a long way to managing your taxes as low as possible in retirement.