Jumping the Gun On Retirement

Financial advisers usually advise savers to resist the temptation to dip into their pension funds before the traditional retirement age.

"When you're young, it's hard to focus on the fact you'll need quite a bit of money when you get older -- and it isn't going to come from heaven," says Martin M. Heming, an attorney with Reish Luftman Reicher & Cohen in Los Angeles.

But with that standard caveat out of the way, consider the possibilities. First, you need to know the withdrawal rules: Congress imposes a 10-percent penalty tax on qualified retirement funds withdrawn before you reach age 59 1/2 -- in addition to the normal income taxes slapped onto taxable distributions -- unless you roll the funds into an IRA.

Most people who actively save for retirement fall into the 30-percent income bracket, says Gene Stout, CFP, professor of finance at Central Michigan University, so plan to calculate your future withdrawals with that figure as a guide.

Next, check out the fine print of your plan. Some disallow early distributions altogether. If you don't understand the mumbo-jumbo in the summary-plan description, call the plan administrator and stay on the phone until someone clears your confusion. You'll also want to check whether this move might affect areas like joint survivor annuities.

Still game? Then investigate whether these special scenarios fit your situation:

Hardship Cases

Hardship, explains Heming, is when you can't borrow the money from any other source and it's this route or disaster. For example, CMU professor Stout has a friend who was diagnosed with cancer in his 50s and had to choose between taking retirement money for treatments or dying before reaching the plan's sanctified age.

The good news: If you use distributions of defined contribution plans (these include 401(k) and profit-sharing plans) to pay for deductible medical expenses exceeding 7.5 percent of adjusted gross income, you'll dodge that 10-percent penalty. You don't even need to itemize to claim this goodie, says Mary Kay Foss, CPA, past chair of the taxation committee for the California Society of CPAs.

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Occasionally a traditional pension plan's rules will allow participants to withdraw stashed dollars to prevent foreclosure or rent eviction, but you'll need to prove this is the last resort. More commonly, employers providing defined contribution plans (such as 401(k) and profit-sharing plans) offer this option. Even then, the administrators can require you to take a loan from the funds rather than a straight payout -- and if you don't pay it back in time, says Foss, you'll be socked with the penalty tax on top of your woes.

Foss could condone small-business owners touching the money if the business losses cancel out the 10-percent penalty. "Eventually all these qualified plans and IRAs will be taxed as ordinary income," she says. "So if there's a way you can use them to offset a deduction you might lose otherwise, it really makes sense to do that."

However, bankruptcy and huge debts in general aren't justification for withdrawal from Heming's point of view because money in your pension plan is not subject to creditors.

Have you gotten wind that the traditional pension plan from your former employer may be converting to a cash-balance plan? Don't let talk of imminent plan changes scare you into withdrawing funds early (unless the company is financially distressed), because new rules do not apply to old accounts. By law, once you leave a company, your deal is locked in, so the terms of your vested interest in a defined benefit plan cannot change. So when rumors swirl about conversions to a cash balance plan, it's generally the current employees who face a butt-kicking, not you.

The Specialized Cases

When life gets complicated, tapping into retirement funds before their maturity might be your ticket to overall financial health. Consider these scenarios:

  • Business investment. Your next-door neighbor, the smartest guy in the world, plans to start a business in his garage and you have a chance to get in on the ground floor. If you choose to take out the retirement money for this purpose, you'll have to pay ordinary income taxes and a penalty if you're under 59 1/2. But after that, if the company goes gangbusters, you're looking at paying capital gains taxes on appreciation, currently at 15 percent. If the project goes bust, you can write off the losses on your tax return.
  • Subsidized early retirement. Rich Koski, a principal at Melon Human Resources and Investment Solutions in New York, has clients whose value on their pensions peaks early in their retirement eligibility. Explains Koski: " The problem you have with that is, there's a big difference between the value peaking in an actuarial sense, and the value peaking in an economic, put-money-in-my-bank-account sense."

So say you have a deferred annuity starting at age 65 that would pay $1,000 a month. But at 55, the company dangles a chance to take a subsidized early retirement at $600 a month, which represents a 4-percent reduction per year from age 65. If you're still earning wages in the workforce, "You're almost crazy not to take it and bank it, because you're maximizing your value," Koski says.

That's true if your pension provides a cost-of-living adjustment. It's a common clause for public-sector employees and union workers, but according to Koski, very few private-sector plans offer it. So while $600 a month at age 55 may look acceptable, understand that's a permanent reduction in your benefit, and it will erode still further with inflation. "If I can't make more than 4 percent a year by banking this money, and I really don't need it now, this is a bit tougher choice," he admits.

Consider also the possibility that you'll need the funds to pay for a benefit that you may lose when you start collecting the money. Some companies chop off the health care benefits when you start the retirement funds flowing, so your $600 check may have to pay for medical insurance coverage until Medicare kicks in at age 65.

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Lump sum offers. Let's throw out the other big bomb: Say your plan offers a lump-sum option. For example, if you are entitled to an annuity at age 65 equal to $1,000 a month, but an immediate annuity amount of $600 per month at age 55, the plan could offer a lump-sum settlement instead. The catch: IRS rules allow a plan to offer a lump-sum settlement of only the value of the deferred annuity, which can be lower than the value of an immediate annuity.

For instance, at today's interest rates the value of the deferred annuity is less than $80,000, but the value of the immediate annuity is over $100,000. So Koski calculates that over the long term, the one big check isn't nearly as valuable as the $600-a-month offer. Once again, you need to do the tax-bracket boogie to decide your route.

Company stock. Suppose you have a stock bonus plan or an employee stock option plan. If the company tanks, the value of your retirement account goes down the drain with it. Experts need only whisper "Enron" to get this point across. If you're concerned about your company's financial health, or if your allocation to company stock is higher than 10 percent, it may be advisable to take distributions on the stock. The tax ramifications are complicated, so it's best to consult a tax pro or your plan's administrator to get the details.

Stout says that it's better to take distributions on the stock and pay the ordinary income tax on the amount of the value of the stock at the time it went into the plan. If you roll it into another account, you need only pay capital gains rates (15 percent) on the appreciation when you cash it in the next time. Certain pre-1990 distributions from an employee stock option plans even escape the 10-percent penalty tax.

Looming company crisis or no, it's always worthwhile to dip into the pot early any time the stock's value increases tenfold, says Stout.

And if you're in line for nonqualified benefits (these are usually offered only to highly compensated employees raking in more than $200,000 annually) and are in any way worried about the company's stability, turn on the money spigot whenever possible. This holds true for former employees, too. "It may not be the smartest thing economically, but it certainly is the safest because at least you'll get the money before the creditors do if something happens," says Koski.

And if you can get to your pension benefits before your plan is turned over to the federal Pension Benefit Guarantee Corporation due to financial problems at your company, you'll be better off. Not all benefits are guaranteed if the government takes over. They also impose dollar limits on the monthly benefits they pay, which won't be nearly as generous as early retirement parameters.

Dizzy yet? Yes, the twists and turns as you weigh your options require time and careful consideration. "You really have to know the difference between needs and wants in these discussions," says Stout. "God knows the public policy and tax codes have been designed to promote retirement savings, not spending."

Source: bankrate.com - 10-05-2004

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