How to Prepare for a Retirement Plan Distribution

Dean Fox's picture

One of the most important financial decisions that many people make involves the distribution of money from one or more retirement plans. When the time comes to begin making withdrawals, many plan participants are not prepared to make the decisions that may be right for them. Often, they don’t understand the choices available, or they may not anticipate the deadlines for their decisions – so they fail to seek the professional help they need before these deadlines occur. If a retirement plan distribution is on the horizon for you, this article can help you identify important issues to consider. For more personalized assistance, be sure to consult a financial professional well in advance of any distribution deadlines you may face.

It All Starts With a Trigger Event

Any retirement plan distribution begins with a “trigger event.” This is an occurrence that may cause the money in your plan account to be distributed to you under the terms of the plan. The six most common trigger events are: 1) separation from service (i.e., quitting, being fired, or offered early retirement); 2) reaching retirement age; 3) reaching age 59½ in a plan that allows distributions after that age; 4) death; 5) disability; and 6) termination of the plan.

Once a trigger event occurs, participants (or their beneficiaries) normally are entitled to receive their vested account balances, less any outstanding plan loan balances. It would be wise to pay back your loan prior to taking your distribution. Any outstanding loan may be treated as a premature distribution subject to tax and a 10% penalty. For many people, this is the “biggest paycheck” they may ever handle, representing years of personal savings, accumulated earnings, and perhaps even employer contributions.

Perhaps the most important point to make about handling a distribution involves the need to plan ahead for the best way to handle that distribution, based on your personal circumstances. For example, if your company is downsizing and laying off workers, don’t wait for “pink slip day” to seek information or advice. Many other pressures may be swirling around you when the trigger event takes place, and you need time to plan for handling your money wisely.

Your Choices Are Many

One of the first steps in planning for a trigger event is to understand all your choices for handling your money, and then select the best one for you. You will probably have several of the following options for the distribution of your retirement plan money:

Leave money in the existing plan and let it compound. Depending on the kind of plan it is, and its terms, you may or may not have this choice. If you do, however, leaving money in the plan means you will be limited to the plan’s investment choices. You probably won’t be allowed to put more of your own money into the plan after you leave work. However, you may be investing in institutional shares which generally have lower fees than retail share classes outside the plan. Choosing this option, even in the short term, can help you avoid making a mistake in how you take your distribution.

Take an annuity income payout from the plan, if one is offered. This choice converts plan money into a fixed income guaranteed by an insurance company. However, once you accept this choice, you generally can’t change it. The annuity income may provide less purchasing power the longer you live, because of inflation.

Pay tax on the distribution and invest or spend the after-tax amounts. This is usually not an attractive choice – especially if your plan account balance is large. The distribution will be added to your other income (for the year in which you take your lump-sum distribution) – and you could find yourself taxed in the highest income tax bracket. (This means you may pay significantly more in income taxes than if you took your money over time.) In addition, unless you’re age 55 or older and separating from service – or if you are under age 59½ – your distribution also could be subject to a 10% federal tax penalty, on top of any current income tax you may have to pay.

Transfer the money to the plan of your new employer, if the new employer’s plan allows for such transfers. Tax law changes encourage transfers between companies and types of plans. To make this choice work, you’ll need to fill out the appropriate paperwork to ensure that your money is properly transferred from one plan to the other. In this case, as long as you don’t make any withdrawals, you won’t owe current income tax, and all your plan money can continue to grow until you begin receiving it.

You can transfer the money directly to a Traditional IRA in your own name. You must arrange this transfer between the company you are leaving and your choice of IRA provider. In this case, you do not actually receive money and there is no current income tax consequence.

You can receive the distribution and then “roll it over” to a Traditional IRA in your own name. You must deposit money into the IRA within 60 days of receipt. Your current plan provider will withhold 20% of the distribution for federal income tax, so you will have to replace this amount yourself (from other sources) if you want to avoid tax and possible penalty on that portion of the money. If you are planning to do a rollover, try to do the direct transfer described above, since it will enable you to avoid the 20% withholding.

You may transfer money to a Roth IRA, if you qualify. In a Roth conversion, you pay current income tax on the converted amount and then can qualify for tax-free distributions later on, if you meet certain requirements.

Which Choice is Best?

It’s impossible to say which distribution option might be right for you, without carefully evaluating your options. And with so much money at stake, you need to make sure your analysis is thorough and considers both your personal circumstances and your long-term financial needs. That’s why it usually pays to sit down with a financial professional well in advance of a trigger event. Many professionals can help you understand the tax and investment consequences by using retirement distribution software and customized illustrations. They also can explain other choices you may have. When you consider how long and hard you have worked to earn your “biggest paycheck,” it’s well worth the effort to make the most of it with the help of a qualified financial professional.

Prepared by The Guardian Life Insurance Company of America, New York, N.Y. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.