Retirement investing accounts are wonderful vehicles for creating wealth.
The math is pretty straightforward: If you invest $10,000 annually over 30 years and get an average 7% annual return (obviously, some years will test your patience more than others), you will build a nest egg of $944,607.
Hey, as Albert Einstein once noted, compound interest is the “eighth wonder of the world.”
But retirement investing certainly has its own share of potential landmines. That’s why today, we’re going to discuss a few tax issues you might come across on your way to (or in) retirement, and how to prepare for (or deal with) them.
Retirement Tax Issues: Early Withdrawals and 401k Loans
One day, you might get into a financial pinch and need to take an early withdrawal from your retirement account. And in instances like these, the taxes are onerous.
Let’s say you’re 45 years old and withdraw $100,000 from your IRA. You might get an exemption depending on factors such as disabilities, but in general, you can expect to owe $21,000 in taxes, as well as a 10% penalty. In all, you’ll owe about $31,000. Worse, by taking the distribution, you also will have made it much more difficult to achieve your retirement investing goals.
You might also consider taking a loan from your 401k. With a 401k loan, the amount you receive is not taxed, nor is there a 10% penalty.
However, the strategy has its downsides.
According to federal regulations, you can borrow 50% of the amount in the 401k, or $50,000, whichever is less. A loan also has a maximum payback period of five years. Also, if you lose your job, you will need to repay the balance of the loan within 60 days. If not, you will pay taxes on the remaining balance and possibly a 10% penalty.
So before taking a 401k loan, understand that doing so comes with considerable risk.
Retirement Tax Issues: Rollovers
If you leave your firm, you might want to “roll over” your 401k into an IRA. Rollover IRAs allow you to consolidate your assets — an especially helpful tactic if you have worked at different employers over the years — and do so without paying taxes until you withdraw.
You also will have more leeway with your retirement planning, considering that the investment options for an IRA are much more expansive than 401ks, which typically only allow you to buy into a limited number of mutual funds.
But the rollover process can be tricky. Diligence is vital, because if a rollover isn’t done properly, you’ll not only have to pay taxes on the total value of your 401k, but you may pay an additional 10% penalty.
Note that there are three ways to do a rollover: directly (paid from your plan administrator to your new option), trustee-to-trustee (rolling over one IRA into another IRA or retirement plan) or a 60-day rollover (you receive a payout, then must roll it over into an IRA or another plan.
Retirement Taxes Issues: Required Minimum Distributions (RMDs)
When you reach age 70 1/2, you will be required to start taking money out of your retirement investing accounts. These withdrawals are known as required minimum distributions (RMDs), and they’re mandatory with few exceptions.
For instance, you don’t need to take RMDs from a Roth IRA account. If you have a 401k or 403b but still work for the firm where you have your plan, you don’t need to pay RMDs. And at age 70 1/2, you can also postpone your first distribution until April 1 of the following year … but after this, you’ll need to withdraw by Dec. 31 every year for the rest of your life.
The RMD typically starts at roughly 3.7% of your account and increases by a tiny amount each year. If you fail to take distributions, you’ll be socked with one of the most onerous taxes on the books.
For more information, check out my primer on required minimum distributions (RMDs).