Retirement Plan Distributions: How to Take Them

Your basic options

How you can take a distribution, your share of a pension or profit-sharing plan, a 401(k), an IRA, or a stock bonus plan, depends on the type of plan and whatever limits your employer has placed on your choices. Broadly, you can take everything in a lump sum, take some form of annuity, roll the distribution over, take a partial withdrawal, or combine several of these. The rules here get complex quickly, and professional guidance is genuinely worth it before a major withdrawal decision.

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Tax-free withdrawals vs. early withdrawal penalties

Money that went into a plan on an after-tax basis, non-deductible IRA contributions, after-tax contributions to a company plan, or after-tax 401(k) contributions above the pre-tax deferral limit, comes back out tax-free. Everything else is generally taxed at ordinary rates when withdrawn.

Withdrawing before age 59 and a half typically adds a 10 percent penalty on top of regular tax. Several exceptions can avoid that penalty: being 59 and a half or older, being retired and 55 or older (this exception doesn't apply to IRAs), taking substantially equal periodic payments over your life expectancy, being disabled, a withdrawal required by divorce or separation (again, not available for IRAs), certain medical expenses, health insurance while unemployed, and for IRAs specifically, qualified higher education expenses and up to $10,000 for a first-time home purchase.

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Taking everything in a lump sum

A lump sum might make sense to fund a major purchase, take control of investment decisions away from a former employer, or because your plan requires it. It's the standard distribution form for profit-sharing, 401(k), and stock bonus plans, though a plan can restrict it. The tradeoff is real: once funds are withdrawn, the tax-sheltered growth stops, which is one reason many retirees do better preserving the shelter through a rollover, annuity, or partial withdrawal instead of taking everything at once.

Special relief called forward averaging, sometimes called the 10-year tax option, can reduce the tax on a lump sum for those who qualify, though it isn't available if any part of the account was rolled over to an IRA, and it's generally usable only once in a lifetime. It's a narrow benefit worth checking eligibility for before assuming it applies.

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Rolling over the distribution

A rollover moves funds from one plan to another, from an employer plan to an IRA, from one IRA to another, or from an IRA back into an employer plan, without triggering current tax. This is often done to gain more control and investment flexibility than an employer's plan allows, or because a job change or business closure forces a distribution that would otherwise be taxable.

Rollovers preserve the tax shelter and postpone the need to take a distribution, but they come with tradeoffs. A rollover from a 401(k) or profit-sharing plan can eliminate spousal rights that existed under the original plan, since federal law gives a spouse no automatic rights in an IRA the way it does in a pension plan. A rollover also generally eliminates eligibility for lump sum forward averaging. If you handle the rollover yourself rather than through a direct, trustee-to-trustee transfer, the distributing plan must withhold 20 percent for taxes, and you'll need to make up that amount from other funds to roll over the full balance within the 60-day deadline, or the withheld portion becomes taxable. A direct rollover avoids this withholding entirely and is the lower-risk approach.

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Partial withdrawals

A partial withdrawal, anything that isn't a full rollover, annuity, or lump sum, leaves the remaining balance in the plan to continue growing tax-sheltered, while still preserving your ability to choose a different distribution method for what's left later. These are common both before and after retirement, particularly in profit-sharing plans, 401(k)s, and stock bonus plans, and less common in traditional pension plans. Tax treatment follows the same after-tax versus pre-tax split described above: the portion attributable to after-tax contributions comes out tax-free, proportionally, with the rest taxed as ordinary income.

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Creditor protection and state taxes

Federal law generally protects retirement assets from creditors as long as the funds stay in the plan, with an exception for unpaid federal taxes. This protection mainly comes through federal labor law for employer plans, and through bankruptcy law for Keogh plans and IRAs in specific circumstances.

State tax treatment of retirement distributions varies considerably. States with no individual income tax obviously can't tax a distribution at all. Most states that do tax income follow the federal approach of treating distributions as ordinary income, though some grant additional relief for a certain dollar amount of retirement income that federal law doesn't provide. If you're retiring to, or already living in, a different state than where you worked, it's worth checking that state's specific treatment before assuming the federal rules are the whole story.

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