Rules for 401(K) Withdrawals and Taxable Gifts

This week, Gail answers questions about how 401(k) savings are distributed and when individuals must pay a gift tax.

Dear Gail-

How are 401(k) savings distributed? Can a person select monthly payout or lump-sum?


Dear Dale-

The short answer: it depends on what distribution option your 401(k) offers.

According to David Wray, president of the Profitsharing/401(k) Council, the law does not spell out what type of distribution a 401(k) plan must offer. The choice is up to the employer.

Basically, Wray says the choices generally fall into three categories. A plan may offer one or more of these:

1- Lump sum- You clear out your account when you leave the company. If you’re smart, you roll this money into another tax-sheltered retirement plan or IRA. This is the most common option.

2- Annuity- Your 401(k) balance is turned over to an insurance company which guarantees to pay you as long as you're alive, or, in the case of married participants, as long as either you or your spouse is alive.

By law, if you’re married, and if an annuity option is offered, one choice must be a joint annuity with a 50 percent payout to the surviving spouse when one spouse dies. Under the new Pension Protection Act, plans must also include the option of a 75 percent joint and survivor annuity … but, gain, only if they offer an annuity as a payout choice.

3- Leave your money in your 401(k) account and set up your own withdrawal arrangement. Wray calls this “withdrawal at will.” In other words, “you choose when and in what amounts you withdraw money from the plan.”

Joe Stenken, assistant editor in the Tax and Financial Planning department at National Underwriter, says if a 401(k) offers this option, the plan is required to ensure that a retiree over the age of 70½ withdraws at least his “required minimum distribution” each year.

Hope this helps,

Dear Gail,

I just graduated from college [and] want to start building my credit by buying my first piece of property. My parents have offered to give me the money for the downpayment but as I understand it, if they give me more than $11,000 apiece they will owe gift tax on this amount. Is this true?


Dear Jennifer,

You’re on the right track, but your number is out-of-date. This year, if an individual gives another person a gift worth more than $12,000, the amount over is subject to gift tax.

However, gift tax is not necessarily something that is paid in the year the gift is made. Instead, as you point out, it generally comes into play at the donor’s death. And, unless your parents are extremely wealthy, this is probably not a concern.

At the risk of over-simplifying things, in 2006, the so-called “exclusion amount” is $2 million. This is the maximum amount of total assets someone may leave to individuals other than their spouse without having to pay estate tax. $1 million worth of taxable gifts are also covered by the exclusion amount.

Thus, over his/her lifetime, an individual can have made up to $1 million in taxable gifts and not owe any gift tax. At death, he/she could also leave an additional $1 million in assets to beneficiaries other than a spouse without owing estate tax.

Or, there could be some combination of taxable gifts and taxable bequests, such as $500,000 worth of gifts and $1.5 million left at death.

The key is, at most, only $1 million of the exclusion amount can be used to offset taxable gifts.

Assuming your parents are not likely to owe estate tax when they die or to give away more than $1 million each in taxable gifts, they should not owe any gift tax on the amount they give you to jumpstart your career as a real estate mogul.

You’re lucky to have such generous parents!


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