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Big 401(k) withdrawals trigger big tax bills I am 68 years old and my wife is 61. I have a full-time job and a part-time job. My wife has a full-time job. Our combined income in 2003 was $59,500, which includes my Social Security benefits of $700 a month. We have $7,000 in a savings account, $72,000 in my employer-sponsored 401(k) account, and my wife has $86,000 in her employer-sponsored 401(k) account. We have no debt other than our mortgage of $79,000 at a 4.25 percent fixed rate with about 8.5 years left. I am planning to start withdrawing money from my 401(k) account within the next year or so in order to pay down our mortgage before my actual retirement in a couple of years. Will there be any tax consequences, assuming our income stays roughly the same in the next two or three years? Would I be violating any 401(k) withdrawing rules? Since each 401(k) is designed by the employer which sets it up, you should check with yours to make sure there are no withdrawal limitations. If it turns out that there are limitations, you could simply roll it over into an IRA -- a move that would trigger no tax consequences -- and thus put yourself into the driver's seat. However, if your aim is to pay off most of your $79,000 mortgage balance over the course of two or three years using the 401(k) money, there are two problems. The first is that such sizable withdrawals from the 401(k) would indeed increase your tax bill, and probably quite significantly. Remember, the contributions you made to the 401(k) were simply tax-deferred, not tax-free. And whatever investment returns you have earned within that account have the same status and will be taxed as income when withdrawn. I can't understand why you are in such a hurry to pay off a 4.25 percent mortgage. If your 401(k) money is invested in anything but the most conservative investment vehicles, you are likely earning considerably more than that within the 401(k). And if not, you could roll the 401(k) money into an IRA and invest it to produce a better income stream. Although I don't advise this as a wise investment in this interest-rate climate, as this is written you could get as much as 4.8 percent on a fully insured five-year CD. Also, by paying off the mortgage, you would lose the advantage of deducting your interest payments on your federal income tax return. What you could do is to mentally earmark the mortgage as paid off simply by embarking upon a course of annual withdrawals from the 401(k) that are equal to the annual mortgage payments. If you have a normal level of tax deductions, you could do this without moving beyond the 15 percent federal tax bracket, although your actual tax bill would rise to reflect the amount of the withdrawals. By taking withdrawals over the course of the next 3, you would reduce the level of the mandatory withdrawals that you would face after attaining the age 70, thus increasing your financial flexibility when you enter full retirement. My spouse and I are both 32. I earn $175,000 per year and my spouse earns $76,000. Our income puts us out of range of a Roth IRA or a traditional IRA that would be deductible. We max out on 401(k) contributions ($13,000 each per year, with no employer match) and we have $120,000 combined balances in those accounts, invested in a mix of Fidelity stock funds, plus IRAs of $28,500 in Selected American Shares fund and $4,200 in Legg Mason Value Primary fund. Our only debt is our mortgage. Now that we have purchased our home, we will save about $4,500 per month in addition to our 401(k) contributions. This money is currently in money market accounts. We have $60,000 in emergency savings, also in the money markets. Should we bother with nondeductible IRAs? What should we do with our $4,500 per month in savings? We have no long-term financial goals other than retirement at 70. J.S., Boston You can both establish accounts that would provide you with additional emergency cash and also take advantage of nondeductible contributions to IRA accounts. My suggestion would be to continue fully funding your 401(k) programs, advancing the amount of your contributions as the limits increase. Do the same with traditional IRA accounts for both yourself and your wife, again increasing the amount as the limits rise. Then divide the remaining savings amount -- $48,000 for this year at this point -- evenly between a tax-deferred investment and a taxable account. For the tax-deferred investment, I suggest a variable annuity account, invested in a vehicle such as the Vanguard Variable Annuity Equity Index account. This is basically a clone of the Vanguard Index 500 fund but with a small overlapping of insurance qualifying it for tax-deferred growth within the account. Since you will be putting in after-tax dollars, when you withdraw in retirement only the percentage of the withdrawal that represents the investment returns within the account will be taxable. Because of the insurance element required to attain the tax-deferred state, the returns will be a bit lower than on a taxable investment. But the amount is small and the tax advantage is worth it. Count on such an account to average returns about one half of 1 percent lower than what will be generated by a taxable Index 500 account. As for the $24,000 a year that will be going into your taxable savings, I suggest that you put this money either in Massachusetts municipal bonds or in a mutual fund invested in municipals that are free of both Massachusetts and federal income taxes. This, of course, is a conservative investment, and the returns will be minimal. But you've got to face the fact that at your income level, taxes are your big problem, and with your aggressive savings program, taxes will get to be a bigger and bigger headache as the years go by. The money that you will be salting away in the muni accounts can be viewed as providing the financial flexibility and the income which is generated from those accounts could be similarly reinvested, again keeping it from the reach of the taxman. There wouldn't be a great deal on the tax-free side; if you followed the $2,000 monthly investment these for 38 years and achieved average 4 percent returns, you would have only a little more that $2.1 million there. And if you religiously followed the investment program outlined above, the largest accounts would be the two 401(k)s and your IRAs. The problem there is that the mandatory withdrawals that would have to begin after age 70 would be enormous, as would be the accompanying tax bills. The money in the variable annuity accounts would at least have the advantage of being free of the age 70 withdrawal requirements, but there would also likely be substantial tax bills coming when you make withdrawals there. What you will need is additional investments that will give you the advantage of managing your tax bill in retirement. The best of these is direct ownership of common stocks. You don't need to do this right away, but eventually you will want to talk to a stockbroker about buying stocks with long-term growth prospects, minimal dividend levels, and solid finances which should dictate that the companies will still be around in 40 years or so. Pension checks are taxable income I recently took an early retirement from my company, which is a major air carrier. Is there anything preventing me from reinvesting my monthly earned company pension payment into another retirement fund? I am 53 years old and am seeking employment for another 10 years. Will my pension be tax exempt if the total amount is reinvested and untouched until 62? T.L., Boston If you have elected to receive pension checks from your former employer, these amounts will be taxable as income. You may, of course, invest these amounts however you please, including in tax-deferred investment options such as IRAs or in variable annuity plans. But that move will not affect your liability for these payments as income. Had you elected to take your pension in the form of a lump sum, it could have then been rolled over into an IRA, where the money would have enjoyed tax deferral until it is withdrawn. But it sounds like that is too late at this point.
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