Helping clients tap retirement savings

Chances are, you have clients in financial distress, with a need for ready cash. Just a few years ago, they might have taken out a home equity loan or sold their home. Today, selling a home is difficult, and home equity lines of credit are being shut down. If clients have few assets in taxable accounts or go through those holdings rapidly, they may have to turn to tax-deferred retirement accounts for spending money. If they come to you for help in tapping those assets most efficiently, with the lowest tax cost, what can you suggest? First, remind clients that withdrawing money from a 401(k) or individual retirement account not only means they will owe income tax, it also subjects them to a 10% early-withdrawal penalty if they withdraw funds before they're 591/2. The 10% penalty does not apply to 401(k) withdrawals if the participant leaves the company at 55 or older. Suppose one of your clients is Paul, who is laid off from his job at 57. If he rolls his 401(k) balance into an IRA, he will be subject to a 10% penalty on all distributions until 591/2. Instead, you might suggest that Paul keep his money in the 401(k), at least until he's 591/2. Because he left the company when he was 55 or older, Paul can take penalty-free distributions from his 401(k). While some clients who leave their jobs between 55 and 59 might do better to leave money in their 401(k) to avoid the 10% penalty on future withdrawals, other clients may benefit from rolling over 401(k) money into an IRA. Among the various exceptions to the 10% penalty are the higher- education and first-time-home- purchase exceptions, which apply to IRA withdrawals but not to distributions from 401(k)s. When these exceptions apply, it's better to do the IRA rollover and withdraw the funds penalty-free. Two other tactics for avoiding penalty-free distributions should be viewed with caution — taking a series of substantially equal periodic payments, known as a 72(t)s, or taking 401(k) loans. Substantially equal periodic payments are available to IRA owners and to 401(k) participants who have left the company. The rules are complicated. Users can choose among three methods, but it's easier to see how much a client can take penalty-free by going to an online 72(t) calculator. No matter which method a client chooses, they must maintain the 72(t) payment schedule for five years or until they're 591/2, whichever comes later. If they modify the payments in any way, by any amount (including taking more than is required), all distributions before 591/2 are subject to a 10% penalty plus interest. Because of these restrictions, 72(t)s may work best for clients in their mid- to late 50s who are confident they can maintain the schedule for five years. Clients who are in their early 50s or younger may face too many uncertainties to commit themselves to such a long requirement. Clients who participate in 401(k) or other employer plans often have another option: They can borrow from the plan. Typically, loans can be up to 50% of the vested account balance, with a $50,000 ceiling. Clients who take these loans not only avoid the 10% penalty, they avoid income tax. Paperwork is modest, there's no credit check, and loan repayment goes to the client's retirement fund. So what's the problem? In the current economic climate, a client could lose his job, and if that happens, many companies require that any outstanding 401(k) loans be repaid within 60 days. If a client is unable to repay the loan on time, unpaid amounts are treated as taxable distributions, and the 10% early-withdrawal penalty applies for clients younger than 591/2. Consequently, a 401(k) loan should be considered only by clients with no other source for needed funds, and then only if they are very secure about their jobs. The last resort for cash should be withdrawals from Roth IRAs. Although the funds can be withdrawn tax-free, leave Roth accounts alone if at all possible, since they will be so much more valuable later on to provide a tax-free retirement. With that said, it may make sense to access Roth IRA funds to pay current living expenses in order to keep taxable income lower and thus reduce the amount of taxes that have to be paid when clients are having a difficult time making ends meet. Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com. For archived columns, go to investmentnews.com/iraalert.