Hello, I am Michael Westbrook, licensed financial advisor with CUSO Financial Services, L.P. (CFS*) at Piedmont Advantage Investment Solutions. Happy New Year and welcome back to my blog, “Ask Michael” where I will share answers to frequently asked questions over a variety of financial topics and provide objective guidance to help you achieve your financial goals.
This month’s financial Q&A will pertain to Taking Distributions from IRAs and Employer Retirement Plans. If you have more questions similar to these, I personally invite you to contact me today for a no-obligation review of your present financial situation. I also encourage you to tell a family member or friend that has concerns about the market or retirement planning to contact me. If you would like to receive our monthly financial newsletter and market updates, you can be added to our mailing list by signing up on the right hand side of the website which is another valued benefit of membership at Piedmont Advantage Credit Union.
Can I take money from my IRA without any penalty?
It depends. If you are 59½ or older, you can take money from your traditional IRA without penalty. In contrast, if you withdraw from your IRA before age 59½, the taxable portion of your distribution may be subject to a 10 percent penalty on top of whatever income taxes you owe on the distribution. This penalty, known as the premature distribution tax, is intended to discourage people from exhausting their IRA funds before they retire.
However, there are some exceptions to this rule. Premature IRA withdrawals made by a disabled person may be exempt from the penalty. If an IRA owner dies before age 59½, distributions paid to you as a beneficiary of the account are not subject to the penalty. If you need supplementary income, you can take IRA distributions as a series of “substantially equal payments” over your life expectancy or the joint life expectancy of you and your beneficiary. These distributions will avoid the penalty as long as you don’t modify the payments within certain time frames. Subject to limits and conditions, the penalty tax generally will not apply to IRA distributions taken to pay qualifying medical expenses, health insurance premiums while unemployed, higher education costs, and qualified first-time home-buyer expenses (up to $10,000 lifetime from all your IRAs). It also does not apply to amounts rolled over from one IRA to another (assuming you follow the rules for rollovers), to conversions of traditional IRAs to Roth IRAs, to amounts that the IRS levies from your IRA to cover your tax bill, or to qualified reservist distributions. Other exceptions may also apply.
Qualified distributions from your Roth IRAs are federal income tax–and penalty tax–free. Distributions are qualified if you satisfy a five-year holding period, and you are (a) age 59½, (b) disabled, (c) deceased, or (d) you have qualified first time home-buyer expenses. The taxable portion of nonqualified distributions from your Roth IRAs is subject to the same 10 percent penalty rules that apply to traditional IRAs. (Special rules may apply if you take a nonqualified distribution from your Roth IRA within five years of a conversion.)
What are my options if I inherit an IRA or an employer retirement savings plan account?
If you don’t want the money, you can always disclaim (refuse to accept) the inherited IRA or plan funds. But if you’re like most people, you will want the money. Your first thought may be to take a lump-sum distribution, but that’s usually not the best idea. Although a lump sum provides you with cash to meet expenses or invest elsewhere, it can also result in a huge income tax bill (in most cases, due all in one year). A lump-sum distribution also removes the funds from a tax-deferred environment. Fortunately, you probably have other alternatives.
If you are the designated beneficiary (i.e., you are named as beneficiary in the IRA or plan documents), you can take distributions over your remaining life expectancy, which spreads the income and tax liability over a number of years. You must calculate the annual required minimum distribution (RMD) amount that must be withdrawn each year using IRS life expectancy tables. (You can always withdraw more than the minimum amount in any year, but you will generally be subject to a 50% tax penalty on any required amount that is not withdrawn.) Yearly distributions from the IRA or plan must begin by December 31 of the year following the year of the original account owner’s death. If there are other designated beneficiaries and separate accounts have not been set up, the oldest beneficiary must be used for the life expectancy calculation. (Note: An employer-sponsored retirement plan can specify the distribution method that beneficiaries must use.)
You may have other options as well. If the IRA owner or plan participant died before he or she began taking RMDs, you can generally elect to distribute the entire interest in the IRA or plan within five years of the owner’s or participant’s death. (In this case, you don’t have to begin taking distributions the year after death.) If the IRA owner or plan participant died after beginning to take RMDs, you may be able to spread distributions over the owner’s remaining life expectancy (calculated in the year of death) if that period is longer than your own life expectancy. (Be sure to first withdraw the RMD for the year of death, if not yet taken by the IRA owner/plan participant.) Again, keep in mind that an employer-sponsored retirement plan can specify the distribution method that beneficiaries must use. If your choices are limited by a plan, you may have the ability to transfer the plan funds to an IRA established in the deceased IRA owner’s or plan participant’s name — the rules that apply to inherited IRAs would apply to the transferred funds.
If you are a surviving spouse and a designated beneficiary of the IRA or plan you may also have additional options. You can roll over inherited traditional IRA or plan funds into your own traditional IRA or retirement plan. If you’re the sole beneficiary, you can also leave the funds in an inherited IRA and treat it as your own IRA. In either case, you can then name beneficiaries of your choice and defer taking distributions until the required age (usually 70½). You can generally also roll over (“convert”) non-Roth distributions from an employer plan into a Roth IRA (you’ll generally pay tax on the converted funds in the year of the conversion, but qualified distributions from the Roth IRA will be tax free).
If you’re a nonspouse beneficiary, you generally have far fewer options. For example, you can’t roll the funds in an employer retirement plan into your own IRA or plan account, but you can generally have the funds transferred directly to a properly titled inherited IRA (for example, Joy Smith, deceased, for the benefit of Mary Smith, beneficiary). You can also roll over (“convert”) non-Roth distributions from an employer plan into an inherited Roth IRA (however, you must do so in a direct rollover, and pay tax on the converted funds).
Finally, Roth IRAs are subject to similar rules. If you inherit a Roth IRA, you can take distributions over a five-year period (following the Roth IRA owner’s death) or over your remaining life expectancy. Although original Roth IRA owners are not subject to RMDs, Roth IRA beneficiaries must take them. However, if you are a surviving spouse beneficiary, you may be able roll the assets over to your own Roth IRA or, if you’re the sole beneficiary, treat the Roth IRA as your own. This is significant because, as a Roth IRA owner (rather than beneficiary) you do not have to take any distributions from the Roth IRA during your lifetime. Distributions from an inherited Roth IRA are usually free from income tax if made at least five years after the deceased IRA owner first contributed to any Roth IRA.
Caution: You cannot roll over RMDs. When evaluating whether to initiate a rollover always be sure to (1) ask about possible surrender charges that may be imposed by both the distributing plan and the receiving plan, (2) compare investment fees and expenses charged by your IRA (and investment funds) with those charged by your employer plan (if any), and (3) understand any accumulated rights or guarantees that you may be giving up by transferring funds out of an employer plan. The rules governing inherited IRAs and employer-sponsored plan accounts are complex. Consult a tax advisor for more information.
What is vesting?
Vesting occurs when you acquire ownership. Does your employer offer a retirement savings plan such as a 401(k), traditional pension, or profit-sharing plan? Did you receive a stock option grant as a year-end bonus? These employee benefits and others like them are often tied to a timeline known as a vesting schedule. The vesting schedule determines when you acquire full ownership of the benefit.
For example, your employer grants you 10,000 stock options as a thank-you for a job well done, but it may not be time to go mansion shopping just yet. The options may not actually be yours until you’re vested. If the options are subject to a vesting schedule, you don’t actually own the right to exercise your options until some time in the future. Some stock option plans allow for immediate vesting, while others may delay vesting. Consider these three alternatives for a four-year vesting schedule:
- 25 percent each year
- 50 percent in years two and four
- 100 percent in year four
In addition, there are two permissible vesting schedules for employer contributions to most 401(k) and other defined contribution plans:
- Cliff vesting: This provides no vested benefit until the third year. After three years of employment, you reach the “edge of the cliff,” or vest 100 percent.
- Graded vesting: This provides no vested benefit until year two. For each additional year that you remain with your employer, your benefits vest 20 percent each year. Under this schedule, you’ll be 100 percent vested if you remain with your employer for six years.
Keep in mind that if your employer follows the 100 percent in year-three vesting schedule, you’ll need to stay with your employer for three years before you are vested. Of course, any personal contributions that you make to your employer’s savings plan are automatically fully vested and remain yours no matter how long you stay with the employer.
Defined benefit (traditional pension) plans can have a five year cliff vesting schedule, or a three to seven year graded schedule.
Keep in mind that your employer’s plan can provide for faster (earlier) vesting than the law requires. And in some cases, faster vesting is required by law (for example, employer contributions to a SEP, SIMPLE IRA, or SIMPLE 401(k) plan must be immediately vested). To find out about your specific plan’s vesting schedule, check with your manager or human resources representative, or read your summary plan description.
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*Insurance products and services are offered through CUSO Financial Services, Inc. (“CFS”). Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are licensed through CFS. The Credit Union has contracted with CFS to make certain insurance products and services available to credit union members.