Stay in Your Protective Shell

By Clifton Linton
Senior Writer, mPower

In This Story Lump-sum Psychology Big Tax Bite Lost Investment Opportunity Stay in Your Protective Shell Rollover Strategies

You've got several thousand dollars in bills, and you could also use a vacation. Hey! It looks like your IRA money could just about cover those two expenses. Should you pay off those bills, then fly to Europe?

"No! No! No!," say retirement experts. Even a small IRA balance can pay big rewards at retirement time. So, try to find a way to leave that money untouched.

minute: read this article at a glance.

Financial planners are united on this one point: Leave your IRA money, no matter how small, within the tax-deferred account.

Unfortunately, this sage advice often falls upon deaf ears.

When folks use this money prematurely, what they're really doing is cheating their future, retirement experts say. And, they're using some of the most costly money they could find to do so.

By understanding more about how government-penalty rules and money compounding work, and learning strategies for keeping your money tax deferred, you can reduce the chances of having to work during retirement.

The Lump-sum Psychology

If you're struggling to pay credit-card bills or you covet a new car, your IRA balance might look like the perfect source of cash.

"A lot of people ... say 'here's a down payment on my next car,'" said Trisha Brambley, president of Resources for Retirement Plans, Inc. "It's overwhelmingly tempting to take that money."

Anecdotal evidence shows that many folks use their retirement nest eggs to pay off credit-card bills and rationalize that they're doing this so they can start fresh.

The disheartening trend is that the money is often only a temporary fix.

"Unfortunately, they end up back in the same problem in a year or two," said Ted Benna, creator of the first 401(k) plan and president of the 401(k) Association.

"It's overwhelmingly tempting to take that money." —Trisha Brambley, president of Resources for Retirement Plans, Inc.

Of course, the best solution is to change money-management habits. "Throw your credit cards away. The problem is ... using them to buy things you aren't able to pay for," he said.

The Big Tax Bite

What many workers don't realize is that they pay a heavy price if they make an early withdrawal of their money. They pay high taxes and penalties when they initially take the money, and later they suffer from a reduced retirement balance.

Phillip Cook, a certified financial planner in Torrance, Calif., says retirement funds are some of the most "expensive" money you can tap for day-to-day use. "Make (your retirement account) the last place you go to get money," he said.

Let's look at how costly it can be to take money out of your IRA.

The first cost is the 10 percent early withdrawal penalty if you are under 59½. This penalty may be waived under certain circumstances.

Read More Read our Frequently Asked Questions section for a list of eligible hardship withdrawals.

Next are the income taxes. Any withdrawal is added to your annual income, and this could push you into a higher tax bracket.

Suppose you're 35 years old, single, earn $35,000 annually (putting you in the 28 percent tax bracket), and have a $10,000 balance in your IRA.

If you withdraw that money, you'll have to pay a $1,000 early withdrawal penalty and $2,800 in income taxes. This leaves you with a balance of $6,200, a nearly 40 percent reduction of your original principal.

Let's change our scenario just a bit. Suppose you're 35 years old and married. You and your wife together earn $105,000 annually, putting you into the 31 percent tax bracket.

If you cash out your IRA, you still pay a 10 percent early withdrawal penalty of $1,000, plus $3,100 in income taxes. This leaves you with only $5,900.

Lost Opportunity

There's an old saying that goes "It takes money to make money." What many workers fail to realize is that even a small amount of money, if given enough time to grow through compounding, can become quite large.

Benna offers an example to show how much your money will be worth at retirement.

Take the earlier example of a 35-year-old with a $10,000 lump sum in his or her IRA account. Let's assume that money earns a 9 percent annual return. In 30 years, that money would grow to $132,677.

If you withdrew the $10,000 at age 35, and wanted to replace the final amount, you would have to contribute $973 a year for 30 years, Benna said.

The chart below shows the missed opportunity for workers of various ages who withdraw a $10,000 nest egg.

Stay in Your Protective Shell

The key to protecting your retirement balance is to avoid paying the penalties and too much tax. You want to keep as much of the money for yourself as you can. Let's take a look at some withdrawal and rollover rules so you can plan a money-preserving strategy.

You can get your money out of a traditional IRA penalty free at age 59½. Prior to that, you'll be assessed a 10 percent early withdrawal penalty. These penalties aren't assessed if you qualify for an IRS-approved hardship withdrawal.

If, however, you have a Roth IRA, you can access your original contribution at any time. Also, earnings can be withdrawn tax-free from your Roth IRA once you have had a Roth IRA for five years, and one of the following conditions applies: you turn 59½; you use the money for the purchase of a first home; or, you become disabled or die.

Regardless of whether you're taking the money after age 59½, making a hardship withdrawal, or making a withdrawal and paying the penalty, you will have to pay income tax on any money you take out.

The withdrawal will be added to your annual income and you will be taxed at a rate based upon the total of the two.

TIP: If you're 59½ or older and retire from work, you may want to delay making an IRA withdrawal until a year when you don't have salary income. That way, you will be in a lower tax bracket and will pay less tax on your withdrawal.

However, there is one way to get at your money penalty free, before reaching age 59½. You need to set up an annuity-payment schedule from your IRA.

Here's how this rule works: The IRS will allow any IRA-account holder to start receiving distributions as they are part of a series of "substantially equal payments" over your life or over the lives of you and your beneficiary.

The distributions must be calculated using an IRS-approved method. Further, the IRS says you must receive payments for at least five years or until you reach age 59½, whichever is longer. If you're 58 and start taking these payments, they must continue until you're 63. If you're 53, the payments must continue until you reach 59½.

Another way to avoid a big tax bill is to avoid taking a lump-sum distribution from your account when you reach retirement. "If you take it piecemeal, you only pay the taxes at the time" you actually withdraw the money, said David Bennett, certified financial planner and owner of Total Financial Concepts in Los Angeles.

If you had a $1 million nest egg and took it in a lump sum, you would have to tell the IRS you received $1 million in annual income and you would have to pay $400,000 in income tax. On the other hand, if you're single and take $60,000 a year, you would pay $16,800 in taxes, as you would fall into the 28 percent tax bracket.

Rollover Strategies

At some point, you may decide to switch IRA providers. There are two ways to do this: a trustee-to-trustee transfer or a 60-day rollover.

A trustee-to-trustee transfer is an easy way to move money and ensure that it's not taxed at the time you move it. To do this, open an IRA at a new provider, fill out the appropriate forms, and the money will be sent directly from one account to the other.

A 60-day rollover is a little more complicated. You ask for a withdrawal from your old IRA provider. When you receive the check, you have 60 days to roll it into a new IRA. The onus is on you to make sure you don't miss that deadline.

Bennett advises, "as a general rule, you should avoid the (rollover) and do a trustee-to-trustee transfer. The money goes directly between the companies and the IRS is never notified of the transaction."

"Make (your retirement account) the last place you go to get money." —Phillip Cook, certified financial planner in Torrance, Calif.

When you make a 60-day rollover, your former IRA provider is required to notify the IRS of your distribution. Make sure you keep records of when you deposit the money into your new account so you can prove that you didn't miss the deadline if you're audited.

You can make as many trustee-to-trustee transfers as you want to in a year. However, the IRS will only allow you to make one 60-day rollover per year, per account.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Stay in Your Protective Shell

By Clifton Linton
Senior Writer, mPower

In This Story Lump-sum Psychology Big Tax Bite Lost Investment Opportunity Stay in Your Protective Shell Rollover Strategies

You've got several thousand dollars in bills, and you could also use a vacation. Hey! It looks like your IRA money could just about cover those two expenses. Should you pay off those bills, then fly to Europe?

"No! No! No!," say retirement experts. Even a small IRA balance can pay big rewards at retirement time. So, try to find a way to leave that money untouched.

minute: read this article at a glance.

Financial planners are united on this one point: Leave your IRA money, no matter how small, within the tax-deferred account.

Unfortunately, this sage advice often falls upon deaf ears.

When folks use this money prematurely, what they're really doing is cheating their future, retirement experts say. And, they're using some of the most costly money they could find to do so.

By understanding more about how government-penalty rules and money compounding work, and learning strategies for keeping your money tax deferred, you can reduce the chances of having to work during retirement.

The Lump-sum Psychology

If you're struggling to pay credit-card bills or you covet a new car, your IRA balance might look like the perfect source of cash.

"A lot of people ... say 'here's a down payment on my next car,'" said Trisha Brambley, president of Resources for Retirement Plans, Inc. "It's overwhelmingly tempting to take that money."

Anecdotal evidence shows that many folks use their retirement nest eggs to pay off credit-card bills and rationalize that they're doing this so they can start fresh.

The disheartening trend is that the money is often only a temporary fix.

"Unfortunately, they end up back in the same problem in a year or two," said Ted Benna, creator of the first 401(k) plan and president of the 401(k) Association.

"It's overwhelmingly tempting to take that money." —Trisha Brambley, president of Resources for Retirement Plans, Inc.

Of course, the best solution is to change money-management habits. "Throw your credit cards away. The problem is ... using them to buy things you aren't able to pay for," he said.

The Big Tax Bite

What many workers don't realize is that they pay a heavy price if they make an early withdrawal of their money. They pay high taxes and penalties when they initially take the money, and later they suffer from a reduced retirement balance.

Phillip Cook, a certified financial planner in Torrance, Calif., says retirement funds are some of the most "expensive" money you can tap for day-to-day use. "Make (your retirement account) the last place you go to get money," he said.

Let's look at how costly it can be to take money out of your IRA.

The first cost is the 10 percent early withdrawal penalty if you are under 59½. This penalty may be waived under certain circumstances.

Read More Read our Frequently Asked Questions section for a list of eligible hardship withdrawals.

Next are the income taxes. Any withdrawal is added to your annual income, and this could push you into a higher tax bracket.

Suppose you're 35 years old, single, earn $35,000 annually (putting you in the 28 percent tax bracket), and have a $10,000 balance in your IRA.

If you withdraw that money, you'll have to pay a $1,000 early withdrawal penalty and $2,800 in income taxes. This leaves you with a balance of $6,200, a nearly 40 percent reduction of your original principal.

Let's change our scenario just a bit. Suppose you're 35 years old and married. You and your wife together earn $105,000 annually, putting you into the 31 percent tax bracket.

If you cash out your IRA, you still pay a 10 percent early withdrawal penalty of $1,000, plus $3,100 in income taxes. This leaves you with only $5,900.

Lost Opportunity

There's an old saying that goes "It takes money to make money." What many workers fail to realize is that even a small amount of money, if given enough time to grow through compounding, can become quite large.

Benna offers an example to show how much your money will be worth at retirement.

Take the earlier example of a 35-year-old with a $10,000 lump sum in his or her IRA account. Let's assume that money earns a 9 percent annual return. In 30 years, that money would grow to $132,677.

If you withdrew the $10,000 at age 35, and wanted to replace the final amount, you would have to contribute $973 a year for 30 years, Benna said.

The chart below shows the missed opportunity for workers of various ages who withdraw a $10,000 nest egg.

Stay in Your Protective Shell

The key to protecting your retirement balance is to avoid paying the penalties and too much tax. You want to keep as much of the money for yourself as you can. Let's take a look at some withdrawal and rollover rules so you can plan a money-preserving strategy.

You can get your money out of a traditional IRA penalty free at age 59½. Prior to that, you'll be assessed a 10 percent early withdrawal penalty. These penalties aren't assessed if you qualify for an IRS-approved hardship withdrawal.

If, however, you have a Roth IRA, you can access your original contribution at any time. Also, earnings can be withdrawn tax-free from your Roth IRA once you have had a Roth IRA for five years, and one of the following conditions applies: you turn 59½; you use the money for the purchase of a first home; or, you become disabled or die.

Regardless of whether you're taking the money after age 59½, making a hardship withdrawal, or making a withdrawal and paying the penalty, you will have to pay income tax on any money you take out.

The withdrawal will be added to your annual income and you will be taxed at a rate based upon the total of the two.

TIP: If you're 59½ or older and retire from work, you may want to delay making an IRA withdrawal until a year when you don't have salary income. That way, you will be in a lower tax bracket and will pay less tax on your withdrawal.

However, there is one way to get at your money penalty free, before reaching age 59½. You need to set up an annuity-payment schedule from your IRA.

Here's how this rule works: The IRS will allow any IRA-account holder to start receiving distributions as they are part of a series of "substantially equal payments" over your life or over the lives of you and your beneficiary.

The distributions must be calculated using an IRS-approved method. Further, the IRS says you must receive payments for at least five years or until you reach age 59½, whichever is longer. If you're 58 and start taking these payments, they must continue until you're 63. If you're 53, the payments must continue until you reach 59½.

Another way to avoid a big tax bill is to avoid taking a lump-sum distribution from your account when you reach retirement. "If you take it piecemeal, you only pay the taxes at the time" you actually withdraw the money, said David Bennett, certified financial planner and owner of Total Financial Concepts in Los Angeles.

If you had a $1 million nest egg and took it in a lump sum, you would have to tell the IRS you received $1 million in annual income and you would have to pay $400,000 in income tax. On the other hand, if you're single and take $60,000 a year, you would pay $16,800 in taxes, as you would fall into the 28 percent tax bracket.

Rollover Strategies

At some point, you may decide to switch IRA providers. There are two ways to do this: a trustee-to-trustee transfer or a 60-day rollover.

A trustee-to-trustee transfer is an easy way to move money and ensure that it's not taxed at the time you move it. To do this, open an IRA at a new provider, fill out the appropriate forms, and the money will be sent directly from one account to the other.

A 60-day rollover is a little more complicated. You ask for a withdrawal from your old IRA provider. When you receive the check, you have 60 days to roll it into a new IRA. The onus is on you to make sure you don't miss that deadline.

Bennett advises, "as a general rule, you should avoid the (rollover) and do a trustee-to-trustee transfer. The money goes directly between the companies and the IRS is never notified of the transaction."

"Make (your retirement account) the last place you go to get money." —Phillip Cook, certified financial planner in Torrance, Calif.

When you make a 60-day rollover, your former IRA provider is required to notify the IRS of your distribution. Make sure you keep records of when you deposit the money into your new account so you can prove that you didn't miss the deadline if you're audited.

You can make as many trustee-to-trustee transfers as you want to in a year. However, the IRS will only allow you to make one 60-day rollover per year, per account.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.