Don’t Let the Rules Overtax Your Retirement
June 7th, 2008 | by admin |Due to common pension plan requirements and Social Security rules, ages 55, 60, 62, and 65 often surface as benchmarks in retirement planning. But planning for your 70th year and beyond could also be crucial because of Social Security and tax rules that change when you reach age 70 and 70½.
Social Security presents the more straightforward issue: Although you can start receiving your benefit when you turn 62, the underlying formula will raise your benefit slightly each year—until you reach 70. Here’s a very simple hypothetical example of the difference that waiting could make. You were born Jan. 1, 1960, and your current salary is $150,000. According to the calculator on the Social Security Web site, your benefit at age 62 would be $1,680 per month in current dollars. At your full retirement age of 67, the benefit would be $2,425 per month, and at 70, you would receive $2,992. Once you are 70, the amount would rise with annual cost-of-living adjustments, but there would be no other financial advantage to delaying.
When Can You Withdraw Money?
My previous column, "Timing Your Social Security Benefits" (BusinessWeek.com, 12/6/07), lays out factors other than your age—such as your other potential income sources—to consider before choosing the date to start your benefit.
The second rule relates to withdrawing money from your retirement accounts. In general, you can remove money from a 401(k) or traditional IRA starting at age 59½, without incurring a 10% penalty. (See IRS Publication 590 for a list of exceptions and for details on all IRA rules.) After this age, you can start withdrawals any time you want, and for any amount you want or need.
What many people don’t realize is that once they reach 70½, the decision to withdraw funds is no longer discretionary. A tax rule mandates you to take out a specified amount annually—known as a Required Minimum Distribution (RMD)—by Apr. 1 in the year after you turn 70½. This sum is based on a life expectancy formula for you and a spouse who’s your beneficiary, and you must pay income tax on it. Failure to withdraw will get you a penalty of 50% of the amount you were supposed to have taken out. (There is no RMD for withdrawals from a Roth IRA, because your contributions to the account have already been taxed.)
Account-Rich But Cash-Poor
With the Social Security and RMD rules in play, the size of your income and the size of your tax bill could both vary quite a bit after you reach age 70, depending on the choices you make. Take this hypothetical example: Charlie retires at 70 and receives $2,900 a month in Social Security benefits. In his first year of taking RMDs he must withdraw $54,000 from the $1.5 million IRA into which he rolled his 401(k) after retiring. This combined income—without even considering income from other sources such as a pension, dividends, or real estate—will almost certainly result in having to pay federal income tax of either 50% or 85% on his Social Security benefit, in addition to the income tax on the RMD.
You should also be aware that if all or most of your income-generating assets are in the retirement account, no matter how lush the account is, you can find yourself cash-poor, says Mari Adams, a financial planner in Boca Raton, Fla. When you need a new car or have to pay for hurricane damage, you’ll have to take money beyond the RMD out of the account and pay the extra taxes. And the IRS will not credit the amount of that extra withdrawal toward your next year’s RMD.
