Many people save for their retirement through tax-deferred arrangements such as employer-sponsored retirement plans (a pension or profit sharing plan, for example) or Individual Retirement Arrangements ("IRAs"). A Tax-deferred arrangement means that although income tax will eventually be payable on all assets held in the retirement plan or IRA, this tax will not be due until the assets are distributed to the participant or to his or her beneficiaries.
The advantage of a tax-deferred arrangement is that the assets that would have otherwise been used to pay income tax can be invested, increasing the total assets available at retirement age. For example, if you pay $3 of tax on every $10 you earn, you can invest only $7, but if the tax could be deferred and the entire $10 invested, there could be substantially more money available at retirement.
Avoid Withholding On Plan Distributions
If you are entitled to receive a distribution from a retirement plan, you may, generally, continue the tax deferred advantages of the retirement plan by transferring the plan assets distributed to you to an IRA (often referred to as "rolling over" plan assets). If the plan assets are not rolled over, you will be required to pay income tax on the value of the assets distributed to you from the retirement plan. In addition, if you are not at least 59 1/2 years old when the assets are distributed, an additional tax (known as an excise tax) equal to 10% of the assets distributed to you may also be payable.
The rules relating to rolling over retirement plan distributions to IRAs were once pretty simple. Basically, you received a check and had 60 days in which to deposit the check in an IRA or another employee-sponsored pension or profit sharing plan. If the deposit was made in time, no tax was currently due.
However, as a result of a change in the law that took effect in 1993, if you receive a distribution from a retirement plan and if you do not elect to have the amount of the distribution paid directly to an IRA or another qualified retirement plan, the plan must withhold 20% of the amount of the distribution and pay that amount to the IRS as a deposit against your income tax liability.
I you receive the distribution and then decide to roll it over into an IRA or other retirement plan, and if you still want to defer the entire amount of income tax otherwise due, you must deposit not only the portion of the distribution that you received, but also additional money out of your own pocket equal to the amount withheld by your plan. You will be entitled to a refund of the amount withheld by your plan, but not until after you have filed your income tax return for the year in which the distribution was made.
For example, if you are entitled to a $100,000 distribution from your retirement plan and you do not elect to have the distribution rolled over directly to an IRA, the plan will withhold $20,000 and distribute $80,000 to you. If within 60 days you decide that you want to roll over the entire distribution to an IRA, you must deposit $100,000 in the IRA to completely eliminate any current tax on the distribution. Because you only received $80,000 from the plan, the other $20,000 must come from your other assets or from monies you borrow.
Another important rule relates to when distributions are required to be taken from an IRA or retirement plan. Basically, beginning when you reach age 70 1/2, you must start to take annual distributions from your retirement plans and IRAs so that your retirement assets will be distributed over your life expectancy, or over the joint life expectancies of you and your beneficiary (often your spouse).
You must take the first of these required distributions no later than April 1st of the year following the year in which you reach age 70 1/2. However, if you wait until April 1st of the year following the year in which you reach 70 1/2 to take the first required distribution, you will still be required to take a second distribution (the one for the current year) before December 31st of that same year. The receipt of two distributions in the same year may cause you to incur more income tax than if you had taken your first required distribution in the year in which you reach age 70 1/2.
Assume, for example, that you reach age 70 1/2 in 2000. You will be required to take a distribution for 1999, but you are allowed to defer the actual payment of this amount until April 1, 2001. However, you must also take a distribution for 2001, before the end of that year. If you wait to take your 2000 distribution until calendar 2001, you will have to pay income tax on two distributions in the same calendar year. The extra distribution could cause a portion of the distributed funds to be taxes in a higher income tax bracket, offsetting the benefit of deferring until 2001 the 2000 required distribution.
If you would like more information concerning IRAs or retirement plans, contact Levun, Goodman & Cohen or see your tax advisor.