NEW YORK – This week's topics: Withdrawing from retirement plans and saving for college tuition.
I want to draw a lump sum distribution. What are my total consequences?
I am 54. Also, could you address SEPP (Substantial Equal Periodic Payments)?
Dear "J" —
You don't say from what type of retirement plan you want to withdraw a lump sum, but your consequences are the same: when you take money out of a tax-deferred plan such as a 401(k) or IRA, you trigger income tax on this amount. Whatever amount you withdraw will be considered part of your other 2001 income, which could send you into a higher tax bracket.
In addition, by withdrawing this money before you are 59 ½ years old, you will also be slapped with a 10% penalty.
Let's assume you're single and have taxable income of $27,050, which puts you in the 15% tax bracket this year. However, you figure a quick way to double your income is to withdraw an equal amount from your retirement plan. Here's how it roughly breaks down:
On the first $27,050 you'll pay income tax of $4,058. But the additional income from your retirement plan pushes you into the next tax bracket. As a result, the next $27,050 (from your retirement plan) is taxed at 28% — an additional $7,574 in taxes. On top of this, you will owe an early withdrawal penalty of $2,705 on the retirement money.
Total tax and penalty on lump sum alone: $10,279. In other words, you just lost 38% of your withdrawal. Instead of $27,050, you end up netting $16,771.
If it's an IRA you're taking the money from, there might be a way to at least avoid the 10% early withdrawal penalty. (Forget about escaping the tax.) In fact, the IRS has provided a number of "excuses" which allow you to tap your IRA prior to age 59 ½ without penalty. Among other things, this would include using the withdrawal to pay for higher education expenses, buying a first-time home, medical expenses that exceed 7.5% of your adjusted gross income, or if you become disabled. (Note that these apply to IRAs, not other retirement plans.)
Or, as you mention, you can simply take money out of your IRA via what the IRS refers to as "substantially equal period payments," (SEPP). Essentially, this involves taking out roughly the same amount of money each year. However, you don't get to decide how much. The IRS has conveniently provided three formulas for your use and each will give you a different withdrawal amount. Furthermore, once you start this process, you cannot stop until you have taken "substantially equal" withdrawals for either 5 years or you reach 59 ½ — whichever takes longer.
But you're not proposing this. You want your money in a single lump sum. Lump sum withdrawals — particularly before the age of 59 ½ — are financial disasters and should only be considered as a last resort.
Think long and hard, my friend —
I was wondering what the best vehicle would be for putting money into a college fund for immediate use. My son will be going to college next year, so I was planning on putting the maximum amount that my wife and I can contribute ($4,000?) into some sort of IRA so that we would at least get the tax benefit of using that money for tuition and fees and education expenses.
Am I correct in thinking that there are some types of IRAs that allow you to make tax and penalty-free withdrawals for college education?
And that I can reduce my current and future tax liability by contributing the maximum to an IRA over the next seven years as both of my children go through college?
Dear Mike —
You've got a number of things confused here. But let's make this abundantly clear: money needed for any type of short-term goal (less than 5 years) ought to go into an account which is not going to fluctuate in value. In other words, think "CD" or "money market" for your oldest son's college tuition funds.
Both traditional and Roth IRAs allow you to withdraw as much money as you need to cover higher education expenses for yourself, your spouse, your children or your grandchildren without incurring the usual 10% penalty for early withdrawals (see above letter). But you still owe taxes on this money- either when you take it out (traditional IRA) or before you put it in (Roth).
And since you bring it up, let me dispel a major misunderstanding people have about Roth IRA money used for college expenses: any earnings you withdraw form a Roth prior to age 59 ½ are subject to income tax if you are under 59 ½ and the account is less than 5 years old.
But that's not the point in your case. The issue is, what would you invest that money in once it is inside an IRA? Anything other than a short-term, liquid account (e.g. CD, money market fund, savings account) is going to move up and down with the financial markets. So the value of the account on the day you need to write the tuition check could be less than what you need.
As for your younger child, consider investing via a Section 529 college savings plan. With a 529 plan you invest after-tax dollars in an account which — like a traditional IRA — allows your money to grow tas-deferred.
There is no income tax due on the earnings until the money is withdrawn. If it's used for qualified higher education expenses, the money is taxed at the student's tax rate — not the parents', as with an IRA. For more on 529 plans, check out www.savingforcollege.com.
With only 7 years to go before your second child starts college, you'll want to choose a 529 plan with a fairly conservative investment option (mostly bonds, cash and perhaps some exposure to blue chip-type stocks). Although this is more likely to fluctuate in value than CDs/money market funds , you should get a slightly better return and you've got more time to recover from any downtowns.
There is no magic account that allows you to avoid taxes, no matter what it's used for. You either pay Uncle Sam today, or you pay later.
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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.