Corrected on 1/2/08: An earlier version of this article did not mention that different 401(k) distribution rules apply to business owners.
As consumers we have learned to play by other people's rules to avoid getting burned by fees. We try to use our own bank's ATM, get paranoid about how many minutes we are using up on our cellphones, and tuck money away into 401(k)'s and IRAs to lower our tax bills. But, after years of stashing cash in these retirement plans to avoid taxes, there is also a tax penalty if you don't take the money out in a timely manner—and it can bite.
Here is how you can avoid a hefty tax when drawing down money from your retirement accounts.
Keep track of your age. Uncle Sam has been letting you accrue interest on the money in your IRA and 401(k) tax free for many years, and he finally wants to cash in. Everyone age 70½ or older with a traditional IRA must take what is known as an annual required minimum distribution, or RMD, and it is taxed as income. The specific amount of the distribution changes from year to year. For 2007, the number is calculated by dividing the year-end balance of all your IRA and 401(k) accounts by your life expectancy as determined by the Internal Revenue Service.
If you fail to take that amount of money out of your IRA and report it as taxable income, the IRS imposes a 50 percent tax penalty and still taxes you anyway. So, if you are required to redeem $1,000 from your IRA and you fail to do so, the IRS claims $780: a $500 penalty for not making a withdrawal and the $280 income tax you should have paid on the income, assuming you are in a 28 percent tax bracket. IRA distributions are checked through mandatory IRS reporting.
These rules apply to employee 401(k)’s too, unless you are still working. But they don't affect Roth IRAs or Roth 401(k)'s because you've already paid taxes on contributions to those accounts.
Don't play the April Fool—avoid two distributions in the same year. The year you turn 70½, you have until April 1 of the following year to take your distribution. Every year after that, you have until December 31 to take your distribution. Many financial advisers recommend not waiting until the April 1 deadline to take your first distribution, because then you'd have to take two distributions in the same year. That would increase your income and might move you up to a higher tax bracket. "I would recommend beginning taking distributions in the year they turn 70 to avoid that possibility of having to take two distributions that are taxed as ordinary income in one year," says John Barton, an investment adviser for CenterPointe Wealth Management in Wichita.
Compare retirement accounts. If you have multiple IRA accounts, you must include all the IRA balances in your distribution calculation, but you don't have to take money out of each one. "All the IRS cares about is that you take out the correct total fee and not the amount withdrawn from an individual account," says Jeremy Welther, a financial adviser for Brinton Eaton Wealth Advisors in Morristown, N.J. "If you have an account with higher fees, you may want to take it from that account as opposed to one that is doing better."
You can also choose based on an IRA's performance. "If you have invested in equities or stocks and have had remarkable performance, you may want to take your RMD from the gains that have been made there rather than giving them back to the market," Barton says.
But 401(k)'s are a different story. If you’re an employee and still working, you can delay distributions until you retire no matter what your age. (If you’re at least a 5 percent owner of the business maintaining the retirement plan, however, you cannot delay distributions.) But RMDs must be calculated separately for your 401(k) and taken from that account, cautions Ed Slott, an IRA distribution expert and author of Your Complete Retirement Planning Road Map: "You generally want to roll it over to an IRA. You take control of your money; you don't have to call the company any time you do something."
Notify your heirs. Even death doesn't eliminate required distributions. Beneficiaries of your retirement accounts must take them by the end of the year of death to avoid penalties, if the RMD had not already been taken that year. The first distribution amount is based on the age of the deceased IRA owner. The beneficiary's age is used thereafter.