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Taxes on Retirement Income

Planning ahead can minimize taxes when you start withdrawing money from your retirement plans.

If you have a defined contribution plan, such as a 401(k) or a 403(b), you must decide how to take retirement income when the time comes. Not only do you want to minimize the income tax you'll owe, but you also want to avoid the penalties for withdrawing money too soon or, perhaps more important, for taking too little each year after you turn 70½.

There are several ways of handling withdrawals from your account, so you'll need to figure out how each method works in order to know which suits you best. Your employer should provide some helpful information on your alternatives, and their tax consequences, but you may still want professional advice.

Lump-sum withdrawal

Taking all your retirement money in one lump-sum cash payout can result in a significant tax bill, especially if you have accumulated enough investments to push you into the highest tax bracket for the year you withdraw. Future earnings on amounts you reinvest are also taxed, as are any long-term capital gains that result from sales of assets in your portfolio. But qualified dividend income and long-term gains are taxed at a rate lower than your regular tax rate.

Direct rollovers

You have the option to roll over your retirement plan assets into an individual retirement account (IRA). The advantages include maintaining the tax-deferred status of your account while being able to invest the assets as you choose. You owe income tax at your regular rate on your withdrawals as you make them.

One approach is to arrange a direct rollover. You do this by having your plan administrator transfer the money to the custodian of your IRA on your behalf. Generally you provide the IRA account information to your employer to initiate the process.

Indirect rollovers

If you decide to move your retirement plan assets into an IRA yourself, your employer will withhold 20% of the total you want to move. The amount that's withheld will be refunded after you file your next tax return, provided you have deposited the entire value of your withdrawal including the 20% that was withheld into the IRA within 60 days.

The advantage of this method is that you have the use of your money for the 60 days between taking it out of your retirement account and the deadline for depositing it in your IRA. But a serious pitfall is that the amount that's withheld – the 20% – is considered a taxable distribution if you don't deposit the full amount within the required period.

Let's say you have $100,000 in a company plan and do an indirect transfer. The company withholds $20,000 and gives you $80,000. You must still deposit $100,000 in the IRA within 60 days to avoid taxes and penalties. That means you'll have to come up with $20,000 from other sources, such as a savings or investment account.

If you deposit only the $80,000, you'll owe income taxes on the $20,000 that was withheld. If you are younger than 59½, you may also owe a 10% early withdrawal penalty of $2,000. And once you miss the deposit deadline, the tax-deferred status of the money you don't deposit is gone forever.

Early withdrawals are sometimes okay

You generally must pay a 10% penalty for withdrawing money from an employer's retirement savings plan before you turn 59½ if you don't roll it over into another tax-deferred plan. But there are several exceptions:

  • You may take money at any age as an annuity, which means you'll receive approximately equal annual payments for at least five years or until you turn 59½, whichever is longer.
  • You may make withdrawals at any age if you're totally and permanently disabled.
  • Your beneficiary may withdraw the assets if you die.
  • You may withdraw money from your plan if you retire at age of 55 or later.
  • You may withdraw at any age if you use the money for deductible medical expenses.

Minimum withdrawals

The law requires you to begin withdrawing money from your retirement savings plan by April 1 of the year following the year in which you turn 70½, unless you are still working. In that case, you may postpone withdrawals until the April following the year you actually retire. That exception doesn't apply to withdrawals from traditional IRAs, which must begin when you turn 70½, or if you own 5% or more of the company.

If you don't take the required minimum each year, you owe a penalty of 50% of the amount you should have withdrawn but didn't. In most cases, your plan administrator or IRA custodian will calculate the amount you must withdraw. If you purchase an annuity with your plan assets, your annual payments will meet the minimum.

Social security benefits

Depending on how high your total income is when you draw Social Security benefits, you may be taxed on 50% or as much as 85% of your Social Security income. You may also be penalized if you go on working after you start receiving benefits. In 2006, if you're under full retirement age you'll lose $1 of benefits for every $2 you earn above $12,480. The year you reach full retirement age, you can earn up to $33,240 without penalty. But after reaching full retirement age, you don't lose any benefits when you work.

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This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information. • Lightbulb Press, Inc., 112 Madison Avenue, New York, New York, 10016, Tel: 212-485-8800, www.lightbulbpress.com.

Any tax or legal information in this website is merely a summary of our understanding and interpretations of some of the current income tax regulations and is not exhaustive. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation. Wells Fargo Funds Management, LLC, Wells Fargo Funds Distributor, LLC, nor any of their representatives may give legal or tax advice.

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