Making the Right Distribution Decision

Which Choice is Right for You?

If you are en route to retirement or you are changing jobs, there are important decisions you need to make ... sooner than you may think. How will you preserve the retirement funds you have accumulated over an entire career to provide the income stream you will need for your future? There are several options to consider that can help you protect the security you’ve earned from unnecessary or untimely income tax treatment.

What Decisions Need to Be Made?

• Do you want the money now? If you want to take all or part of your money in cash, you will pay ordinary income taxes – and probably a 10% penalty – on whatever portion is not rolled directly into an individual retirement account or another employer’s plan.
• Do you want to pay the tax later? If you want to keep deferring taxes and maintain control over your money, you can transfer your accumulated assets directly from the current plan into an IRA.
• Do you want to pay a one-time tax today? If you want to take advantage of the Roth IRA and ultimately withdraw your money tax-free, you must first roll over the assets from your employer’s plan into a traditional IRA.

Your individual circumstances will determine which option is right for you. This booklet provides information on different options, but is an overview at best. Raymond James financial advisors can help you review your own personal situation before making a decision regarding your distribution. We’ll take the time to understand your individual needs and objectives, then help you implement the appropriate strategy.

Taking the Money Now

If you want the money now it will cost you. By law, 20% will be withheld toward federal income taxes. So right away you will have lost the use of one-fifth of your retirement assets. If you are not at least age 59½, disabled, or leaving your job after the age of 55, you are subject to an additional 10% federal tax as a premature withdrawal penalty. State taxes may also apply.

Employer Stock Distribution Options

Participants who have highly appreciated employer stock should consider taking an in-kind distribution of the stock, instead of rolling over to an IRA. Here’s why:

• Upon distribution, ordinary income tax is paid on the original cost basis of the stock. The cost basis is the price at which the stock was allocated to the participant.
• The difference between the cost basis and the current fair market value is called the Net Unrealized Appreciation. This NUA remains tax-deferred until the securities are sold.
• When the stock is sold, the NUA or appreciation in the stock is taxed as a long-term capital gain.
• The advantage to this strategy is the difference between ordinary income tax rates and long-term capital gain rates.

In order for this strategy to work, individuals must take a lump-sum distribution of all assets in the plan to qualify, although they can roll part of the assets to an IRA. The rollover should be direct to avoid the mandatory 20% withholding.

An example should clarify how this works:

Kevin, 50 years old, retires from Sun Company with 1,000 shares of company stock with a fair market value of $50,000. Kevin paid $10 per share for a cost basis of $10,000. His NUA is $40,000 ($50,000-$10,000.)

If Kevin elects to take a lump-sum distribution, assuming a 25% federal tax bracket, he will pay $2,500 on the original cost basis and a 10% penalty for being younger than 59½, or $1,000. The $40,000 of appreciation, or NUA, is tax-deferred until sold, at which time it would be taxed at the long-term capital gains rate of 15%.

If Kevin elected to roll to an IRA and then take a distribution, he would pay ordinary income tax on whatever amount he distributed. If he distributed the $50,000, the tax would be 25% of $50,000, or $12,500 (plus the 10% penalty for being younger than 59½ or $5,000).

In Kevin’s case, there is a significant difference in the tax owed.

Forward averaging. If you were born before January 1, 1936, you may use 10-year forward averaging. The tax on a lump-sum distribution is due for the tax year in which the distribution is made. Forward averaging is a method of calculating the tax that may result in a lower tax burden. Forward averaging can only be used once in your lifetime, so consideration should be given as to the possibility of a future lump-sum distribution. As Raymond James financial advisors, we can discuss this option with you in more detail.

Deferring All Taxes Until Later

If you want to avoid any current taxes, you must have your retirement plan money transferred directly into an IRA (referred to as a “direct rollover”), leave it in your former employer’s plan or transfer it directly into a new employer’s plan.

It is important to understand the distribution options and procedures of your former employer’s plan. If you want to avoid the 20% withholding tax, you must specifically request a direct rollover. The withholding tax is required if you physically take possession of the distribution amount, even if you intend to roll it over to an IRA.

Summary of an IRA Rollover

Benefits:

• No current taxes due on rollover amount.
• Assets grow tax-deferred in the IRA.

How It Works:

• To avoid the 20% withholding tax on qualified plan distributions, you must elect a direct rollover to the IRA.
• If you do not elect a direct rollover, 20% will be withheld upon distribution. You can still avoid taxes on the distribution by rolling over to an IRA within 60 days of receipt of your distribution. (Example: Joe takes distribution of his $100,000 employer profit sharing account when he changes jobs. His former employer sends $20,000 to the IRS and a check to Joe for $80,000. If Joe can access $20,000 from another source, the entire $100,000 can be rolled over to an IRA, thus avoiding any tax consequence on the distribution. When he files his tax return, the $20,000 that was withheld would, in effect, be refunded.) If not, the $20,000 will be deemed a distribution. It will be taxed at Joe’s ordinary income tax rate and penalized 10% since Joe is under age 59½.
• Stock received in a distribution can be rolled over, or can be sold and the proceeds of the sale can be rolled over.

Pay the Tax Now ... Tax-Free Distributions Later

The Taxpayer Relief Act of 1997 introduced the Roth IRA. The investment in a Roth IRA grows tax-free and is distributed tax-free under certain circumstances.

A distribution from a qualifi ed pension or profit sharing plan may not be rolled over into a Roth IRA. However, an individual can roll over a distribution from his or her employer’s qualified plan into a traditional IRA and then elect to convert or roll over that IRA into a Roth IRA.

The advantage to this strategy is that after the tax is paid on the initial distribution from the IRA, there is no further tax, as long as the money stays in the Roth IRA a minimum of five years and the person reaches age 59½, dies, becomes disabled or the money is used for a qualifi ed fi rst-time home purchase ($10,000 lifetime maximum).

Key Provisions of the Roth IRA

Distributions from a traditional IRA may be rolled over or converted to a Roth IRA if an individual’s adjusted gross income (AGI) is not more than $100,000 (same for married or single) in the year of the rollover or conversion. An individual can choose to roll over or convert any portion of his or her traditional IRA to a Roth IRA.

The distribution amount is treated as ordinary income, but is not included as income for purposes of determining the $100,000 AGI limit. A distribution from a traditional IRA being rolled over or converted into a Roth IRA is not subject to the 10% premature withdrawal penalty tax imposed on withdrawals from traditional IRAs before age 59½.

Common Questions about Retirement Plan Distributions

What is a lump-sum distribution?

It is a payment or payments (occurring within one calendar year) from a pension or profit sharing plan. It represents all contributions made by you or your employer, as well as all earnings.

What is an IRA rollover?

An IRA rollover is a tax-sheltered vehicle for retirement benefits received (a “distribution”) from an employer-sponsored plan. Taxes on all dividends, interest and gains are deferred until withdrawn. Because the assets in an IRA rollover are untaxed dollars, they compound tax-free and grow more rapidly than money placed in a taxable account.

What type of distribution can be rolled over to an IRA?

To be eligible for placement in an IRA rollover, the distribution must be considered an “eligible rollover distribution.” An eligible rollover distribution must meet the following criteria:

1. It must be paid from a “qualified” plan or “employer IRA”:

• Pension plans,
• Profit sharing plans,
• 401(k) plans,
• Employee stock ownership plans,
• Keogh plans (pension or profi t sharing plans for self-employed persons),
• 457 state and local government plans,
• SEP IRA or
• SIMPLE IRA

Distributions from 403(b) plans established for teachers, hospital employees and other employees of nonprofit organizations may also be eligible for rollover treatment.

2. The payment must not be made in any of the following forms:

• One of a series of substantially equal payments based on life expectancy,
• One of a series of installment payments payable over 10 years or more,
• All or part of a required minimum distribution,
• A return of any excess deferrals or excess contributions, a refund of life insurance costs, or as a deemed distribution due to a loan default or
• A hardship distribution.

What if I want to roll over part of my distribution and keep part for immediate use?

You may roll over any part of your lump-sum distribution and keep the rest. However, 20% of what you don’t transfer directly into an IRA rollover will be withheld against taxes. If you have a $10,000 distribution and you do a direct rollover of $9,000, then $200 (20% of the $1,000 you didn’t roll over) will be withheld.

What are the advantages of placing a qualified distribution into an IRA rollover?

Placing an eligible distribution into an IRA is the only way to avoid current taxes, and perhaps a 10% penalty tax as well. Rolling over your distribution will allow the full value of your accumulated benefits to continue to grow and be available for your retirement years.

What are the tax reporting requirements related to rolling over my qualified plan distribution?

Under current regulations, there are no special tax forms to file when rolling over a qualified distribution to an IRA.

Soon after the end of the year in which you receive the distribution, the trustee of your employer’s plan will send a Form 1099-R to the IRS and forward a copy to you. The 1099-R indicates the amount of your distribution. This amount is entered on your income tax return (IRS Form 1040). If you elected a direct rollover of the total distribution into an IRA, it is excluded from total taxable income. (If you do not roll over the full distribution, the part that you keep will be included in your taxable income for the year.) Once the rollover is completed, current law does not require any other IRS filings or reports.

What happens to the voluntary after-tax contributions I’ve made to my employer’s plan?

If you made voluntary after-tax contributions to your employer’s retirement plan, you may roll these funds directly into your IRA or place these funds in a regular taxable account.

Is it possible to combine my distribution with another IRA I already have?

Yes. Eligible distributions placed in an IRA rollover retain “portability.” Portability allows you, at any time, to return the amount in your IRA rollover into another employer sponsored pension or profit sharing plan in which you participate and which provides for such transfers.

Eligible rollovers from qualified 403(b) or 457 plans that are commingled with IRA assets and/or each other retain their qualified status and are eligible to later roll into other employer sponsored plans (assuming those plans allow rollovers).

Can I elect a rollover to an IRA even after the age of 70½?

There are no age restrictions for electing an IRA rollover, but by April 1 of the year following the year in which you reach age 70½, you must begin to make withdrawals, which cannot be rolled over.

What is the tax status of an IRA distribution?

IRA distributions will be taxed as ordinary income in the year received and may be subject to premature withdrawal penalties.

What are my IRA distribution options?

IRS rules govern when these assets can be removed from your IRA without penalty.

The Tax Reform Act of 1986 adopted an early withdrawal program that allows a person to withdraw from an IRA prior to age 59½ without penalty. You can withdraw money from an IRA before age 59½ if you receive distributions as part of a series of equal payments based on your life expectancy. The payments must continue for at least five years or until you reach age 59½, whichever is longer. For example, if you are age 57, you can begin a series of annual payments but you cannot alter or stop the payment schedule until you are 62. If you begin withdrawals at age 52, you cannot alter or stop the payment schedule until you are 59½.

Between the ages of 59½ and 70½, you may withdraw as much or as little from your IRA as you choose. The standard rule is that if you take an IRA distribution before you reach age 59½, the amount distributed is subject to an additional 10% penalty tax.

Beginning with the year you turn age 70½, certain minimum distributions must be taken at least annually from your IRA to avoid substantial penalty taxes. The IRS penalty for not taking the required minimum distributions from your IRA after age 70½ is 50% of the difference between the amount that should have been distributed and the amount actually distributed from the IRA. You should also be aware that you may be required to make estimated tax payments whether or not you request the standard 10% withholding on distributions from your IRA.

Reviewing the Facts

Making an informed decision about your retirement plan assets requires careful consideration of the alternatives. Now that we’ve introduced several possible strategies, the following chart should help you review the benefits – as well the possible drawbacks – of the various options you can choose.

Raymond James financial advisors are equipped with the knowledge and experience to provide a full explanation of all your options and help you make the best possible decision regarding your retirement plan assets. Please contact us if you would like more information about substantially equal payments, required minimum distributions or beneficiary options.