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If you receive a distribution from a qualified retirement plan such as a 401(k), you need to consider whether to pay taxes now or to roll over the account to another tax-deferred plan. A correctly implemented rollover avoids current taxes and allows the funds to continue accumulating tax deferred.

Paying Current Taxes With a Lump-Sum Distribution

If you decide to take a lump-sum distribution, income taxes are due on the total amount of the distribution (except for any after-tax contributions you’ve made) and are due in the year in which you cash out. Employers are required to withhold 20 percent automatically from the check and apply it toward federal income taxes, so you will receive only 80 percent of your total vested value in the plan. (Special rules apply to Roth accounts.)

The advantage of a lump-sum distribution is that you can spend or invest the balance as you wish. The problem with this approach is parting with all those tax dollars. Income taxes on the total distribution are taxed at your marginal income tax rate. If the distribution is large, it could easily move you into a higher tax bracket. Distributions taken prior to age 59½ are subject to 10 percent federal income tax penalty. (Special rules may apply if you were born before 1936.)

Deferring Taxes With a Rollover

If you don’t qualify for the above options or don’t want to pay current taxes on your lump-sum distribution, you can roll the money into a traditional IRA.

If you choose a rollover from a tax-deferred plan to a Roth IRA, you must pay income taxes on the total amount converted in that tax year. However, future withdrawals of earnings from a Roth IRA are free of federal income tax after age 59½ as long as the five-tax-year holding requirement has been met. Even if you are not 59½, your distribution may be tax-free if you are disabled or a first-time home purchaser ($10,000 lifetime maximum), as long as you satisfy the five-year holding period.

If you elect to use an IRA rollover, you can avoid potential tax and penalty problems by electing a direct trustee-to-trustee transfer; in other words, the money never passes through your hands. IRA rollovers must be completed within 60 days of the distribution to avoid current taxes and penalties.

An IRA rollover allows your retirement nest egg to continue compounding tax deferred. Remember that you must generally begin taking annual required minimum distributions (RMDs) from tax-deferred retirement plans after you turn 72 (the first distribution must be taken no later than April 1 of the year after the year in which you reach age 72). Failure to take an RMD subjects the funds that should have been withdrawn to a 50 percent federal income tax penalty.

Of course, there is also the possibility that you may be able to keep the funds in your former employer’s plan or move it to your new employer’s plan, if allowed by the plans. (Make sure you understand the pros and cons of rolling funds from an employer plan to an IRA before you take any action.)

Before you decide which method to take for distributions from a qualified retirement plan, it would be prudent to consult with a professional tax advisor.

What Happens If I Withdraw Money from My Tax-Deferred Investments? Before Age 59½?

Withdrawing taxable funds from a tax-deferred retirement account before age 59½ generally triggers a 10 percent federal income tax penalty, on top of any federal income taxes due. (Distributions from Section 457(b) plans are generally not subject to an early distribution penalty; and the penalty for distributions from SIMPLE plans during your first two years of participation is 25 percent, 10 percent thereafter.) However, there are certain situations in which you are allowed to make early withdrawals from a retirement account and avoid the tax penalty. (Check your specific plan provisions to see whether a particular withdrawal option is available.)

IRAs and employer-sponsored retirement plans have different exceptions, although the rules are similar.

IRA Exceptions

The following distributions are not subject to the 10 percent penalty tax:

• Death of the IRA owner. Distributions to your designated beneficiaries after your death. (Beneficiaries are subject to annual required minimum distributions.)
• Disability. Distributions made due to your qualifying disability.
• Unreimbursed medical expenses. Distributions equal to the amount of your unreimbursed medical expenses that exceed 10 percent of your adjusted gross income in a calendar year.
• Medical insurance. Distributions made to pay for health insurance if you’ve lost your job and are receiving unemployment benefits.
• Substantially equal periodic payments (SEPPs). Distributions you receive as a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary. You must withdraw funds at least annually based on one of three rather complicated IRS-approved distribution methods. You generally can’t change or alter the payments for five years or until you reach age 59½, whichever occurs later. If you do, you’ll again wind up having to pay the 10 percent penalty tax on the taxable portion of all your pre-59½ SEPP distributions (unless another exception applies).
• Qualified higher-education expenses for you and/or your dependents.
• First home purchase, up to $10,000 (lifetime limit).
• Qualified reservist distributions. Certain distributions to qualified military reservists called to active duty.

Employer-Sponsored Plan Exceptions

The following distributions are not subject to the 10 percent penalty tax:

• Death of the plan participant. Upon your death, your designated beneficiaries may begin taking distributions from your account. Beneficiaries are subject to annual required minimum distributions.
• Disability. Distributions made due to your qualifying disability.
• Part of a SEPP program (see above). Distributions you receive as a series of substantially equal payments over your life expectancy, or the combined life expectancies of you and your beneficiary. You generally cannot modify the payments for a period of five years or until you reach age 59½, whichever is longer.
• Attainment of age 55. Distributions made to you upon separation of service from your employer. The separation must have occurred during or after the calendar year in which you reached the age of 55 (age 50 for qualified public safety employees).
• Qualified Domestic Relations Order (QDRO). Payments made to an alternate payee under a QDRO.
• Medical care (see above). Distributions equal to the amount of your unreimbursed medical expenses that exceed 10 percent of your adjusted gross income in a calendar year.
• To reduce excess contributions. Distributions made to correct excess contributions you or your employer made to the plan over the allowable amount.
• To reduce excess elective deferrals. Distributions made to reduce amounts you deferred over the allowable limit.
• Qualified reservist distributions (see above).

If you plan to withdraw funds from a tax-deferred account, make sure to carefully examine the rules on exemptions for early withdrawals. For more information on situations that are exempt from the early-withdrawal income tax penalty, visit the IRS website at www.irs.gov.

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