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Should You Make an Early Withdrawal From Your Retirement Plan or IRA?

December 20, 1996

The government recently granted a 3-year suspension of the 15% excise tax on excess distributions from qualified retirement plans, tax-sheltered annuities and IRAs, effective for calendar years 1997, 1998 and 1999. The fear of confiscatory income taxation on retirement account balances may cause many to make early withdrawals inadvisably. Determining whether taking advantage of the suspension is beneficial can be done only on a case-by-case basis. As a general rule, however, it is more likely than not that the benefits of tax-free compounding obtained by leaving the retirement account balance intact will outweigh the disadvantages of potentially subjecting a larger account balance to the 15% excise tax. Bear in mind that the suspension applies only to the 15% excise tax, not to the ordinary income tax on the amount withdrawn prematurely.

In 1996, the amount that can be withdrawn from a qualified plan or IRA without incurring the 15% excise tax is $155,000 for a person over age 59. Suppose the threshold amount for 1997 remains constant at $155,000. If the individual were to withdraw $250,000 from the plan in 1997, $14,250 in excise taxes would be exonerated under the new law. Thus, assuming an ordinary income tax at 40%, the individual would have a balance of $150,000 after tax. Suppose that the individual invests that balance and earns a 10% annual return before tax. In 15 years, that amount would grow to appropriately $360,000 after tax. Suppose instead the $250,000 remains in the plan and compounds tax-free at 10% annually. At the end of 15 years, the account value would be approximately $1,040,000. Even if the entire amount were then subject to income tax at 40% and excise tax at 15%, the net value of the account balance would be approximately $470,000 as compared to $360,000. The above example is an over-simplification, but illustrates the point.

In contrast, early withdrawal may be advisable if funds would be needed from the plan in the near term or the plan participant is in ill health or is near retirement age and expects that the required minimum distributions would exceed the threshold amount in any event. Additionally, early withdrawal may be advantageous to implement a gift-giving program to avoid or reduce estate taxes if such a program were not otherwise feasible. Probably a far more significant benefit of the new legislation is that it provides a catalyst to conducting a qualified plan and IRA check-up. Particularly for participants nearing their required beginning date (April 1st of the year following the year in which the participant attains age 70), it is crucial to ensure that the beneficiary designations in place appropriately provide the maximum potential benefits from the individual's plans. Even after the required beginning date has passed, it is possible to salvage less than optimal beneficiary designations. Beneficiary designations can be designed in such a way that deferral would continue not only for the joint life expectancy of the participant and the participant's spouse, but also for continuing life expectancy of children or grandchildren. Additionally, trusts can be designated to receive benefits without foregoing the ability to distribute the plan proceeds over the life expectancy of the trust beneficiary.

The new legislation provides benefits as well as pitfalls. Nothing can substitute for crunching the numbers in each case. We would be pleased to assist you in conducting a qualified plan and IRA review at your convenience.

This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.