The Most Tax-Efficient Way to Take a Distribution from a Retirement Plan

April 12th, 2016

Most of us start investing in a retirement plan when we start working. There is a possibility that you may face unique financial situations after retirement. Being prepared for those scenarios and having an understanding of how to take tax distributions from the retirement plan while enhancing your fortune will work in your favor when the time comes.

Distribution from a Retirement Plan

If you receive a distribution from a qualified retirement plan such as a 401(k), the first step is to consider whether you want to pay taxes now or roll over the account to another tax-deferred plan. Implementing a rollover correctly can avoid current taxes, allowing the funds to continue accumulating in a tax deferred manner.

Having a diversified retirement portfolio will offer great flexibility and give you greater returns.

Paying Current Taxes with a Lump-Sum Distribution

If you take a lump-sum distribution, then the income taxes will be due on the total amount of the distribution, in the same year you cash out. The income tax on the total distribution will be taxed at your marginal income tax rate. The advantage of opting for lump-sum distribution is that you can invest or spend the balance in any way you wish to.

If you were born on or before 1936, the following options can help in reducing your tax burden on the lump-sum:

1. 10-year averaging

This option allows you to treat all the distributions as if they were received in equal installments over a 10 year period. Based on this, you can calculate your tax liability using the 1986 tax tables for a single filer.

2. Capital gains tax treatment

With this option, you can have the pre-1974 portion of your distribution taxed a rate of 20% flat. Additionally, if you qualify, the balance can be taxed under 10-year averaging.

You must have participated in the retirement plan for at least five years to qualify for these options. Moreover, you must be receiving a total distribution of your retirement account.

Deferring Taxes with a Rollover

If you are amongst those who don’t qualify for the above options or don’t wish to pay current taxes on the lump-sum distribution, there is one more option – you can roll the money into a traditional IRA. For a rollover to a Roth IRA, you have to pay income taxes on the total amount converted in that tax year. It is crucial to remember that the rollovers must be completed within 60 days of distribution to avoid current taxes and penalties. An IRA rollover will allow your retirement money to compound in a tax-deferred manner.

After you turn 70½ you must start taking annual minimum distributions or RMDs from the tax-deferred plans. If you fail to do so, the funds that were supposed to be withdrawn will be subjected to a 50% federal income tax penalty.

It would greatly benefit you to have a balanced approach. Take from the taxable, tax-deferred and tax-free accounts as this will help in controlling the taxes in an efficient manner. Moreover, it has potential to maintain a portfolio for a longer period of time when the taxes are reduced.

Blossom Wealth Management is known for offering sound financial advice on taxes and estate planning. With a huge list of clientele vouching for the same, we promise on delivering our best services on every occasion. If you find yourself getting overwhelmed with everything related to taxes, estate planning, IRAs etc., you know whom to call.