DISTRIBUTION STRATEGIES
What is the most sensible way of taking money out of your retirement plan so that it will last? It depends, of course, on your personal financial situation as well as your spending expectations during retirement. That's why you should consult with your Financial Advisor to chart a long-term course before you begin distributions, and then to try to stick with discipline to that plan.
Here are some potential distribution strategies to help make your assets last longer:
Retirement Plans like 401(k) or 403(b)
When you retire, you have to decide what to do with your retirement assets, including whether to leave the money in the plan, or roll it over to an IRA. Here are your basic choices:
- Rollover to an IRA. This is one of the most popular strategies, as it takes the money out of the employer's control and puts it into yours, with all the responsibility that entails. Once in a Traditional IRA, you can manage the money any way you want, as long as you start distributions at age 70 ½.
- Leave your money in the plan. If your employer allows you to stay in the plan after you retire, you have the advantage of keeping the same investment options and plan rules. The downside is you may have fewer investment choices, less ability to access your funds quickly, less control of beneficiary designation and distribution planning. Depending on the terms of the plan, you may elect the following types of distributions:
- Take a lump-sum distribution. This option will give you all your cash right away, but at a huge cost. In most cases, you have to pay income tax on the full amount of the distribution (including earnings) in the year received. That can put a real damper on your future saving potential. Remember, you may defer taxation on this money by rolling it into a Traditional IRA. Depending on your age you may also have a 10% premature distribution penalty.
- Take periodic distributions. You may be able to receive a regular stream of monthly or quarterly income from your retirement plan. Typically, plans allow you select an amount to receive, and you're allowed to change that amount once a year, sometimes more. However, periodic distributions are not guaranteed to last throughout your lifetime, as some annuities are.
- Purchase an annuity. Another way to receive regular payments is to purchase an annuity in your IRA with all or a portion of the balance. With this option, you can receive guaranteed income for the rest of your life, your spouse's life, or a certain time period, such as 10 or 20 years. Your annuity payments can be fixed for your entire payout period, inflation-adjusted annually, or based on investment performance within the annuity.
Variable annuities are sold by prospectus. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.
Distributions if earnings are subject to ordinary income tax. In addition, a federal 10% penalty may apply to distributions taken prior to age 59 ½ and surrender charges generally apply.
Using a retirement plan already provides tax deferral. Therefore an annuity should only be used to fund a qualified retirement plan when an investor is interested in the other benefits an annuity has to offer, such as the lifetime income option and the death benefit protection. In order to provide these features there are mortality and risk/administrative expenses with annuities that are not associated with other investments. Guarantees are based on the claims paying ability of the issuer.
Stock options
Stock options are becoming a more and more common way of helping fund retirement. In most corporate stock option plans, you have the right to buy the stock at a pre-set price that is (presumably) lower than the current price. In a so-called "cashless transaction," you simultaneously buy the stock at the lower price and sell at the higher price. This can be a windfall for many people, but there are a number of pitfalls: you typically receive a large sum of cash you must suddenly turn around and invest, there are complicated tax implications for even the simplest stock option transaction, and, of course, so much depends on the performance of one stock. That's why it's vital to consult your tax advisor, as well as your Financial Advisor before making any decisions about cashing out your company stock options.
IRA Wealth Preservation Strategy
For higher-income investors, IRA assets may be subject to estate taxes at the death of either the owner or surviving spouse. You should consult with your tax advisor to help mitigate tax liabilities. Some strategies may include:
- Replace the IRA assets with less heavily taxed assets. This is usually done by taking the taxable distributions from the IRA, often before they are required to be taken at age 70½ but after 59 ½,, and using the money to purchase life insurance in an irrevocable trust. In many cases, this strategy can produce more income and estate tax-free death benefits at your death than if they were left in the IRA.
- Maximize retirement income while you're alive. This means using the IRA for as much of your income needs as you can. A single life or joint and survivor annuity can be designed to distribute the IRA during the lifetimes of the owner and spouse.
- Philanthropic Giving. If you do not need the assets in your IRA, you can designate a charity as your beneficiary and benefit from certain tax rules.
Income in Respect of a Decedent (IRD)
At Wachovia it is apparent that many Investors have accumulated significant wealth during their lifetimes. Over the years, many individuals will become the beneficiaries of estates that will be subject to the federal estate tax burden. One often overlooked concept for these beneficiaries to be aware of is IRD — an IRS term that stands for Income in Respect of a Decedent — that describes inherited income that is subject to federal tax.
An IRA or employer sponsored retirement plan (401(k), 403(b), etc) that is inherited offers a very common example of this tax situation. The income in the plan was earned by the decedent during his or her lifetime, but the tax was not yet paid on the funds remaining in the account at death. The beneficiary must pay the income tax as distributions are taken from the inherited account. So while the taxes are due upon such distributions the IRD deduction may create a sizable reduction in this tax obligation. The IRD deduction is a way for beneficiaries to offset the effect of the double taxation that comes with inherited assets like a tax-deferred retirement account that is subject to federal income tax.
The list of assets/income that qualifies for IRD is extensive and should be discussed with your tax advisor. While Wachovia Securities and its Financial Advisors do not render tax or legal advice, we do hope to educate our clients and prospects on issues that can be important considerations for them and their families.
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