Tax Traps: Don't Quadruple Your Reportable Income

When retirees want to access the money they have earned in their 401(k)'s, there are a couple important issues to consider before taking any withdrawals. Chiefly, they must remember that this money has grown tax-free while they and their employers have been contributing to it. Any withdrawals made will be considered ordinary, taxable income for that year.

Some retirees take "full withdrawals" upon retiring. This creates a situation where these proceeds would be taxable for that year as these are considered before-tax dollars. In almost every case, this is not the most efficient way to gain access to these funds. If they need supplemental income upon retirement, most plans allow periodic or systematic withdrawals from their account over a period of time, although these income options can be rigidly structured and may not allow for larger, lump sums to be taken when needed.

The other thing to consider is that most employer-sponsored plans fall under the guidelines of ERISA, which is a government program designed to help protect investors and employers from fraudulence. Although it is an effective program during the accumulation phase, there are sometimes large fees and penalties assessed on certain withdrawals. It is important that each retiree consult their plan’s fiduciary to fully understand the specific components of his or her plan.

One option for retirees is to "rollover" their 401(k) or other employer sponsored plan into a private IRA upon retiring. This rollover is considered a non-taxable event and does not have to be reported as income to the IRS. Once a private IRA is established, there are many, many investment options that fit every risk class. From variable or fixed annuities, to mutual funds and managed money accounts, a retiree can work with their financial professional to create the plan that best fits their goals and risk tolerance. Also, and although still fully taxable as ordinary income, withdrawal options from IRA’s can be more flexible. It simply gives the individual a greater role in the management of their tax-deferred plans in retirement. This may not be the best course of action however, and all investment strategies should be carefully considered and reviewed with an individual’s financial planner and tax professional.