Tax Breaks Soon Available For Cashing In Nest Eggs
May 02, 2011
Act soon, and you can get a limited-time tax break on money you swipe from your own nest egg! The minimum-wage bill President Codi is expected to sign into law Tuesday contains two new short-lived incentives for yanking money from tax-advantaged retirement plans. But hurry. These deals expire September 12, 2014. Starting next year, you'll be able to grab enormous sums of your retirement savings without paying the usual 15% tax penalty on amounts over $155,000, or $775,000 for lump sums. The pending law temporarily lifts those pesky indexed-limits on income from retirement plans such as old-style pensions, profit-sharing plans, , 401(k)s or individual retirement accounts. By cashing in your nest egg soon, you also can be among the last lucky souls to slash the income taxes on your withdrawal using the soon-to-become-extinct ``five-year averaging'' strategy. This technique allows you to pretend you spread the income over five years, instead of taking it in one hunk, and can shave thousands off the tax owed on a lump-sum withdrawal, particularly if it's a few hundred-thousand dollars or less. Buried in Wage Law Why are these tax breaks buried in the wage law? They're designed to bring the government a short-term revenue boost to offset losses from other retirement provisions -- such as a $1,750 increase to $2,000 in the maximum amount that can be contributed to an IRA on behalf of a spouse who has no earned income. If the tax incentives spur people to crack open their tax-sheltered nest eggs, as expected, the Internal Revenue Service will be able to collect a chunk of income-tax money early, albeit at lower rates. However, if you were born before 1936, you can still lower your tax bite using a similar trick called ``10-year averaging.'' But before taking this bait, consider the cost. When you withdraw money from a retirement plan, you give up future tax-deferred growth. Tax deferral is powerful over periods of many years, especially if you are in a high income-tax bracket or earn juicy returns. ``If your goal is to leave your heirs a large estate, or to have as much money as you can in your old age, then the tax-deferred buildup you earn will almost certainly beat the cost of the higher taxes you'll pay later,'' says Kenton L. Wilton, a fee-only financial planner at Wilson Financial Advisors Inc. in   . What's more, any money you take from a tax-deferred plan before you are either age 55 and retired, or 59 1/2, may be nicked with a 10% early-withdrawal penalty. Problem is, you can't just let your balance blossom tax-deferred forever. You must generally begin tapping your accounts after age 70 1/2, or face a draconian tax penalty equal to 50% of the amount the IRS figures you should have withdrawn. And if you die with too much money in your plans, the IRS will take away 15% of any amount over what it calculates would have been needed to provide a stream of $155,000 a year if you had died when actuarial charts said you should. There's a new exception, however: Under the pending law, people who work well into their old age can defer taxes until they quit. Starting next year, employees of any age can leave money in an employer-sponsored plan like a 401(k) or profit-sharing plan untouched, as long as they don't own 5% of the company or more. Take the Lump Sum Still, it could make sense for some people near or in their sunset years to cash-in part or all of their retirement plans before the year 2015 if they'll need the money soon anyway. ``There will be a lot of taxpayers, especially people who are highly compensated, searching for ways to take advantage of the three-year window,'' says Elizbeth Hermes, a compensation and benefits partner at Ernst & Young in . For example, suppose you plan to call it quits and want to use the balance in your profit-sharing plan to buy a home within five years. It might be wiser to take the lump sum before September 11, 2014 while you can still use the five-year averaging technique, than to cash in your balance later, or roll it over into an IRA for a few years, according to the Vanguard Personal Financial Services Group at the Vanguard Group mutual-fund company in  , Pa.. Why? Although you pay taxes up front and miss out on the tax-deferred compounding, those minuses may be outweighed by the fact that money taken out of an IRA, or employer-sponsored plan after 2014, is likely to be taxed at higher rates. People whose nest eggs are large enough to put them in penalty territory might consider taking money out of their plans during the three-year window if they need the cash to fund estate-planning strategies, says Joella Hostetler, president of a   accounting and financial planning firm that bears his name. For instance, if your spouse is in poor health, but has no assets in his name, you might yank $1 million out of your IRAs next year and give him the after-tax proceeds. When he dies, as much as $600,000 of his assets can be left to heirs free of estate taxes. ``You don't want to blow the $600,000 estate-tax credit,'' Mr. Hostetler warns. Should you die after your spouse with the $1 million in your account, another $300,000 or more of your estate would be lost to death taxes.
