Basic 401(a) withdrawal question

[BigNick]

A friend (here in Europe) has applied for, and thinks he will get offered, a good job at a U.S. university. Whether or not he takes it will depend in large part on pension considerations, as he has a spotty pension record due to frequent job changes earlier in his career.

He is 50 and intends, for the purposes of this calculation, to work until he's 68. I'm going to assume he will get a salary of $117,000, which I believe is approximately the Social Security "wage base". The SS calculator gives me a figure of $2,226/month.

The university will contribute 10% of his salary (up to the SS wage base; 15% thereafter) into a 401(a) plan. No employee contribution required. (There is a 403(b) available for extra employee contributions.) With 5% CAGR and 1.5% inflation, I calculate that he will have accumulated $367,000 gross (worth $285,000 in today's dollars).

My question is, what happens to that 401(a) money at age 68? Does he have to buy an annuity, or can he draw it down as he likes? If the latter, what is the tax situation? If he takes the whole sum (for example, to move it back to Europe), will he have to pay income tax that year on all $367,000?

Thanks for any help - I presume this is fairly basic!

[meierlde]

The first question is which country and is there a tax treaty with the US and what it may say. The is the person on a green card or non resident visa?

[Sunset]

Ignoring the tax treaty issue which is very important not to ignore.

He likely would be better to split his withdrawal across 2 or more years.

Beyond which your 'friend' does not seem like much of a saver. I worked in various places which also meant no pension.
So I saved a lot, easily 25% per year and one year about 60% , so high that my pay check was less than $100 for 2 weeks work.

[meierlde]

Further a non resident typically has 30% of 401k proceeds withheld upon withdrawal, to ensure that taxes are filed. (Again depends on possible tax treaty)

[nun]

Quote:

Originally Posted by BigNick My question is, what happens to that 401(a) money at age 68? Does he have to buy an annuity, or can he draw it down as he likes? If the latter, what is the tax situation? If he takes the whole sum (for example, to move it back to Europe), will he have to pay income tax that year on all $367,000? Thanks for any help - I presume this is fairly basic!

You can do whatever you like with the 401a money, buy a single premium immediate annuity or manage it in a portfolio of equity and bond funds for income. Contributions are made tax deferred and grow free of tax. Then withdrawals are taxed as income.

How your friend is taxed will depend on where he/she is living and the tax treaty.

They will have to comply with US withdrawal rules, so at age 70.5 they must make withdrawals based on their expected life and IRS interest rates, these are called Required Minimum Distributions. The withdrawals are taxed as income at the federal and state level, unless he works for a state university where different state tax rules might apply. If your friend moved back to Europe the tax will be governed by the treaty and citizenship and residency.

For example if your friend is a British citizen and were to retire to the UK there would be no US income or withholding tax on withdrawals from his 401a....it would be taxed by the UK as a foreign pension.

[nun]

Quote:

Originally Posted by meierlde Further a non resident typically has 30% of 401k proceeds withheld upon withdrawal, to ensure that taxes are filed. (Again depends on possible tax treaty)

Agreed for NRAs living in the UK the withholding tax rate is 0%. If you are a US citizen living in the UK you cannot elect zero withholding, as you can if you live in the US, and 20% will be withheld from a 401a that you will have to claim back on your 1040 as UK FTCs usually wipe out any US tax liability.

[BigNick]

Quote:

Originally Posted by nun You can do whatever you like with the 401a money, buy a single premium immediate annuity or manage it in a portfolio of equity and bond funds for income. Contributions are made tax deferred and grow free of tax. Then withdrawals are taxed as income.

The tax treaty issues seem clear. My main question is, when you get to 60 and there's $400,000 in the pot, what can one do with it and how would it be taxed (assuming US residency, for simplicity) in these cases:

1. He buys an annuity. I guess the IRS looks the other way for the ten minutes it takes to withdraw the $400,000 and buy a $400,000 annuity, then taxes the $18,000/year or whatever income he gets.

2. He puts it in some other kind of non-SPIA investment fund. Again, I guess the IRS looks the other way, and then has a way to tax the income from that fund. Are there specific, IRS-approved funds for this?

3. He takes it out in cash. In that case, I presume the IRS will add $400,000 to his taxable income for the year in question (ouch).

My question is prompted by a wish to understand how the differences between those cases are determined by the IRS. I'm sure there are rules to follow, but formally I'm not sure how one would determine between 2 and 3. After all, putting the money into "an investment fund" seems to me to be pretty close to taking it in cash, once it's left the 401(a) context.

[bingybear]

Quote:

Originally Posted by BigNick The tax treaty issues seem clear. My main question is, when you get to 60 and there's $400,000 in the pot, what can one do with it and how would it be taxed (assuming US residency, for simplicity) in these cases: 1. He buys an annuity. I guess the IRS looks the other way for the ten minutes it takes to withdraw the $400,000 and buy a $400,000 annuity, then taxes the $18,000/year or whatever income he gets. 2. He puts it in some other kind of non-SPIA investment fund. Again, I guess the IRS looks the other way, and then has a way to tax the income from that fund. Are there specific, IRS-approved funds for this? 3. He takes it out in cash. In that case, I presume the IRS will add $400,000 to his taxable income for the year in question (ouch). My question is prompted by a wish to understand how the differences between those cases are determined by the IRS. I'm sure there are rules to follow, but formally I'm not sure how one would determine between 2 and 3. After all, putting the money into "an investment fund" seems to me to be pretty close to taking it in cash, once it's left the 401(a) context.

If we guess that US residency is equivalent to US citizen ... If you roll the 401 to an IRA, no tax at that time. If then you buy a SPIA.. still no tax. Will be taxed as the SPIA pays out of the IRA. Note, you likely can go directly to the SPIA... but the insurance company may set this in an IRA... I'm not sure about the details. So that is item 1.

2. If the investment is in a IRA... no tax, outside of an IRA (proper retirement vehicle)... all will be taxed.

3. yep taxed.

It is really pretty simple. Remove the money from proper retirement plans... you get taxed as normal income on the proceeds. It is best to do direct transfers/conversions (custodian to custodian) as they may withhold some $ for taxes and you will only have 60 days to deposit the transfer (making up for the withheld taxes). I wouldn't use the term "looks the other way" with the IRS. You miss the 60 day window... all taxable... and then you end up with a too large of contribution to an IRA.

[BigNick]

Quote:

Originally Posted by bingybear I wouldn't use the term "looks the other way" with the IRS. You miss the 60 day window... all taxable... and then you end up with a too large of contribution to an IRA.

It was a poor choice of words - I meant that they have an official policy of not calling it a cash withdrawal when you roll it over to an IRA, for example. (Until recently, in the UK, you *had* to buy an annuity when a tax-deferred retirement account matured.) But at least I now know what the mechanism is (i.e., you get 60 days to show that the money is back in an IRS-approved structure). I don't think my friend will be taking it all out in cash.

Tax is not likely to be a big problem, as he will probably be retiring in a European country that has a tax treaty with the US. For example, his SS payments will be taxed at about 25.5% by the IRS, but he can deduct that from the (larger) tax that he would probably be paying in Germany or the Netherlands.

Quote:

Originally Posted by Sunset Beyond which your 'friend' does not seem like much of a saver.

That's why I'm asking here for him, rather than him being a member.

Actually, I found out on further questioning that he does have some savings, and an IRA, but I'm not sure what the numbers are. He does not regard himself as very financially savvy, though, so he seems happy to have my advice.

The good news is that if he gets the U.S. gig, it will pay $100K+, so he should be able to build up a decent amount in 15-18 years.

[nun]

Quote:

Originally Posted by BigNick The tax treaty issues seem clear. My main question is, when you get to 60 and there's $400,000 in the pot, what can one do with it and how would it be taxed (assuming US residency, for simplicity) in these cases: 1. He buys an annuity. I guess the IRS looks the other way for the ten minutes it takes to withdraw the $400,000 and buy a $400,000 annuity, then taxes the $18,000/year or whatever income he gets.

Your friend will have the 401a plan with an investment company like Fidelity etc.....but if they are working for a university it will probably be TIAA-CREF. If he buys an annuity he can do it with TIAA-CREF within the 401a. If they wanted to buy an annuity from some one else they can do that as well.....its called using qualified money to buy the annuity. There would be no tax on the money used to buy the annuity as long as your friend follows the IRS rollover rules. All the tax stuff will be taken care of on the forms.

Quote:

2. He puts it in some other kind of non-SPIA investment fund. Again, I guess the IRS looks the other way, and then has a way to tax the income from that fund. Are there specific, IRS-approved funds for this?

The IRS never looks the other way. There are mechanisms in place for the rollover of funds from say a 401a account to an IRA or the retirement account of a new employer.

Employers usually contract with financial companies to provide retirement plans that meet IRS regulations. They will have a range of mutual funds available. You can invest in those however you like and there is no tax on anything inside the retirement account and you can move money around as you like.

There is only tax due when you take money from the account. If you are moving the money to another retirement account or a personal IRA you can do that tax free too. The only time there is tax due is when you take income out to spend. You will tell the retirement fund administrator if you want some tax to be withheld or take it with no tax taken out. At the end of the year company will send you a 1099-R that will show your income and tax withheld. You then enter that on your annual federal and state tax returns.

Quote:

3. He takes it out in cash. In that case, I presume the IRS will add $400,000 to his taxable income for the year in question (ouch). My question is prompted by a wish to understand how the differences between those cases are determined by the IRS. I'm sure there are rules to follow, but formally I'm not sure how one would determine between 2 and 3. After all, putting the money into "an investment fund" seems to me to be pretty close to taking it in cash, once it's left the 401(a) context.

Yes if he cashes it in and takes a lump sum it goes onto his taxable income.

You must realize that you only have to take the income out of the 401a context. You can leave the money in the 401a when you retire or you can move it to an Individual Retirement Account which has the same tax deferral as other retirement accounts like 401a/401k/403b etc.

[bingybear]

Quote:

Originally Posted by BigNick Actually, I found out on further questioning that he does have some savings, and an IRA, but I'm not sure what the numbers are. He does not regard himself as very financially savvy, though, so he seems happy to have my advice. The good news is that if he gets the U.S. gig, it will pay $100K+, so he should be able to build up a decent amount in 15-18 years.

should note... if he has some other pension... likely even government pension (similar to SS), he likely will fall into WEP when filing for SS.

[nun]

Quote:

Originally Posted by bingybear should note... if he has some other pension... likely even government pension (similar to SS), he likely will fall into WEP when filing for SS.

WEP rules are complex. Private foreign pensions will probably fall under WEP, but often foreign Government pensions won't, an example would be the new flat rate UK state pension.

[BigNick]

Quote:

Originally Posted by bingybear should note... if he has some other pension... likely even government pension (similar to SS), he likely will fall into WEP when filing for SS.

Ouch... I went to the SSA's interactive questions page and it seems like he probably will be hit by this. The calculator shows that he will lose SS at the rate of 50% of his external pension, up to a total loss of about 25% of his basic SS entitlement. Good to know.