MINIMIZING TAXES ON YOUR RETIREMENT NEST EGG

After spending years building your retirement nest egg, the time will come when you'll need to make important decisions about when and how to withdraw. The rules governing distributions from retirement accounts are complex and have major tax consequences, reports the Georgia Society of CPAs. Here are some guidelines for minimizing tax obligations on your retirement savings.

COMPANY RETIREMENT PLANS

Most company retirement plans, such as 401(k)s, give retirees a choice between receiving their retirement benefits in periodic payments (in the form of an annuity) or in a lump sum. If you choose an annuity and your retirement plan has been fully funded by your employer, the entire distribution is taxed as ordinary income. If you have made non-deductible contributions, you may exclude from your taxable income the portion of each distribution you can attribute to non-deductible contributions.

When you withdraw your money in a lump sum, you must pay tax on the entire amount in the year of your withdrawal unless you decide to transfer the balance into a rollover IRA. (To avoid a 20 percent withholding tax on your pay out, arrange to have your employer transfer the funds directly to your new IRA).

You may be able to lessen the tax burden on a lump sum distribution by using a five-year averaging election. To qualify for this election, you must be age 59 or older when the distribution is made and have participated in your 401(k) plan for at least five years before the year of distribution. With five-year averaging, you are required to pay your tax in full in the year you receive the lump sum, but you calculate the tax due as if you received the money in equal installments over five years. The savings can be substantial, but you'll need to act quickly; the five-year averaging method will be eliminated for tax years beginning after December 31, 1999.

If you were born before 1936, you may choose to use either five-year or ten-year averaging. If you choose ten-year averaging, you must use the tax rates that were in effect in 1986. With ten-year averaging, you are permitted to elect capital gains treatment at a flat 20 percent tax rate for pre-1974 retirement plan participation. The ten-year averaging method is not slated for elimination.

INDIVIDUAL RETIREMENT ACCOUNTS

Distribution from traditional IRAs -- whether taken in a lump sum or in periodic payments -- are taxed as ordinary income in the year received. Unless you really need the cash, you probably don't want to take a lump sum, especially since you cannot use five-year or ten-year averaging on IRA distributions.

Calculating taxes on IRA withdrawals is especially complicated when your funds consist of both deductible and nondeductible contributions. That's because you need to compute the portion of each distribution that is attributable to nondeductible contributions in order to exclude the correct amount from your taxable income. If you have several IRAs, for purposes of computing the taxable portion of any withdrawal, the IRS regards all your IRAs as one.

Qualified distributions of principal and earnings from Roth IRAs are tax-free once you've held your account for at least five years and are at least age 59 when you make the withdrawal.

TIMING WHEN AND HOW MUCH YOU WITHDRAW

Generally, distributions from qualified retirement plans and IRAs made before reaching age 59 are subject to a 10 percent penalty. However, this penalty does not apply to withdrawals from traditional IRAs after December 31, 1997, when the money is used for certain purposes, such as paying qualified education expenses or acquisition costs for a principal residence (limited to a $10,000 lifetime cap) if you are a first-time home buyer. Keep in mind that distributions from these IRAs are taxable.

You also risk incurring penalties if you wait too long before tapping into your retirement funds. Generally, with an IRA, you must start taking money no later than April 1 of the year you reach age 70. A participant in an employer qualified retirement plan (other than a 5 percent owner) must initiate and receive distributions no later than April 1 following the year in which he or she reaches age 70 or, if later, the year of retirement. Keep in mind that if you do wait until the following year, you also will have to take a second distribution by December 31 of that year.

Minimum withdrawal rules also apply. The amount you must withdraw annually once you reach age 70 is based on your life expectancy or the life expectancy of you and your beneficiary, using IRS life-expectancy tables. Be aware that if you withdraw too little from your retirement plans, you can expect to pay a penalty equal to 50 percent of the amount you should have taken out. These distribution rules do not apply to Roth IRAs.

The Taxpayer Relief Act of 1997 repeals the 15 percent excise tax on distributions above a certain threshold. So, you no longer need to be concerned about penalties for withdrawing too much money.

If you have any questions about the best way to structure distributions from your retirement plan, consult a CPA.

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