What is a Distribution From a Retirement Plan?

After contributing money to your retirement plan for several years, you will eventually have to take out some of that money. These distributions can go toward living expenses, a new home or any other expenses. There are several types of distributions, each with its own rules and impact on taxes. Understanding how distributions work can help you make the best of your retirement funds.

How Do Distributions From a Retirement Plan Work?

Distributions are money that you take out of your retirement plan. You can make any number of distributions each year. People with retirement accounts can end up taking out several types of distributions, depending on when they start.

Age and Eligibility

You can take out money from a retirement plan at any time, but you can only make penalty-free distributions if you are 59 ½ years or older. A few exceptions exist that let you cash in on your retirement accounts without worrying about penalties, even if you are younger than 59 ½ years old. Rules also vary depending on the type of retirement account you have.

Distribution Options

You can choose from several types of distributions to receive your cash. Consumers can select from lump-sum distributions, systematic withdrawals, annuity payments and partial withdrawals. Each option has its own implications and tax considerations, so it's important to understand the specifics of your retirement plan.

Required Minimum Distributions

Required minimum distribution (RMDs) begin when you have reached a certain age. For a traditional IRA and most employer-sponsored plans, you must start withdrawing from your account when you turn 73. The IRS has periodically adjusted this age requirement, and you  can incur penalties if you do not withdraw from your retirement account. RMDs do not apply to Roth IRAs.

Tax Implications

Traditional IRAs and employer-sponsored plans are usually subject to an income tax when you receive them. A Roth IRA’s distributions are tax-free, including capital gains. These differences exist because a consumer uses pre-tax money for a traditional or employer-sponsored plan, while a Roth IRA involves post-tax contributions. A tax professional can walk you through the tax implications that apply to your accounts.

Early Withdrawal Penalties

Early withdrawal penalties apply to distributions taken out before you turn 59 ½ years old. Some exceptions exist, but these distributions usually incur a penalty fee on top of the regular tax payment. Medical expenses, qualifying first-time home buyer expenses and disability expenses are some of the exceptions.

Distribution Planning

How you distribute your retirement funds impacts your taxes, long-term financial health and other elements of your life. It’s important to plan out your distributions instead of withdrawing money at the spur of the moment. Speaking with a financial advisor or tax professional can provide clarity and lead to informed decisions that match up with your financial goals.

What Are the Different Types of Distributions in Retirement?

When you take out money from your retirement account, it is a distribution. The tax treatment for those distributions depends on the circumstances surrounding it. Knowing the different types of distributions can improve your retirement planning and lead to better decisions.

Normal Distributions

Normal distributions are withdrawals you make after turning 59 ½ years old to cover your living expenses during retirement. These distributions give you a steady income source similar to what you had at your job. Building up your retirement account and letting it grow makes it more feasible to maintain your current lifestyle, but you may have to make adjustments.

Early Distribution

Early distributions take place before you turn 59 ½ years old. These withdrawals have penalties and reduce your retirement account’s size. Taking early distributions can make it more difficult to cover expenses when you retire.

Required Minimum Distribution (RMD)

The RMD applies to traditional IRAs and most employer-sponsored plans. Once you turn 73 years old, you must start taking money out of your retirement account unless it is a Roth IRA. You can’t take out $1 per year and keep all of your funds in your retirement account. The minimum distribution is calculated based on your account balance and life expectancy. 

Qualified Distribution

Qualified distributions are tax-free withdrawals from a Roth IRA or a Roth 401(k) account. These distributions are tax-free because they are funded with post-tax money. You already paid income tax before putting that money into a Roth account. You have to wait until the funds have been in your Roth account for five years before taking out a qualified distribution.

Periodic Distribution

Periodic distributions are automatic withdrawals from your account that line up with a designated time interval. You can set up your account for monthly or quarterly withdrawals, depending on your preference. You can change the frequency of distributions at any time. Periodic distributions provide a steady income stream during retirement.

Lump-Sum Distribution

A lump-sum distribution involves taking out all of the proceeds in your retirement account. This strategy can help you cover a large expense. Some people make a lump-sum distribution when changing jobs. The risk with a lump-sum distribution is that the distributions get treated as income for traditional IRAs and employer-sponsored plans. This approach gives you cash now but results in a higher tax bill.

Rollover Distributions

You can transfer funds from one retirement account to another. These rollover distributions usually involve moving funds from an employer-sponsored plan to an individual retirement account (IRA) or vice versa.

You can also do a rollover distribution from a traditional retirement account to a Roth retirement account. This strategy results in an upfront tax payment, but future distributions and capital gains will not be subject to income taxes. If your retirement account grows significantly after the rollover, you can enjoy tax-free capital gains if they are in a Roth retirement account. Make sure you speak with a tax professional or financial advisor before rolling over your account.

How Can I Effectively Manage my Distributions During Retirement?

You work hard to earn money, and it takes discipline to build up your retirement savings. Effectively managing your distributions gives your money more mileage, and these pointers can get you on the right track.

Assess Your Financial Requirements

Create a list of your living expenses and estimate how they will change when you retire. You can save money by trimming discretionary spending and evaluating each expense to determine if it is essential. Consider if you will downsize or maintain your current budget before withdrawing funds from your retirement account. Knowing your financial profile can help you assess how much you need to pull out from your retirement account each month or quarter.

Create a Withdrawal Strategy

A withdrawal strategy gets you clear on how you will withdraw funds and which assets you will sell. You can consider trimming each of your investments to ensure you still have a diverse portfolio or get more conservative with your assets as you get closer to retirement. Automated withdrawals can simplify your strategy and eliminate manual withdrawals. 

Some investors follow the bucket strategy in retirement. The bucket strategy involves grouping your money into multiple buckets with different time horizons. You can have one bucket that addresses your financial needs for the next 1 to 3 years and another bucket that covers your finances for the next 4 to 6 years. Investors can consider acquiring growth investments for further out buckets and using more conservative assets for near-term buckets.

Tax Planning

When you withdraw money from a traditional IRA or employer-sponsored plan, you will incur taxes. Analyzing tax brackets and your income outside of your distributions can help you create an effective tax plan. If you have not yet retired and want tax-free capital gains and distributions, you may want to consider converting to a Roth IRA. 

Review Your Investment Portfolio Regularly

It’s important to stay on top of your investments regardless of your age, but it becomes more important as you get closer to retirement. Retirees don’t have as much time to wait out market corrections and dips. Reviewing your investments to see if they align with your financial goals can lead to a smoother retirement. As investors get older, their risk tolerances, income needs and preferred asset allocation may change. Investors often adjust their portfolios based on how they change in those areas.

Healthcare and Long-Term Care Planning

Healthcare and long-term care expenses may eat into your distributions in the future. Planning for these expenses will leave you more prepared if they arrive. You can also get a step ahead of these costs with long-term care insurance or a health savings account (HSA). These resources can offer extra financial protection if you need healthcare or long-term care.

What Taxes and Penalties Should I Be Aware of When Taking Distributions?

You may incur taxes and penalties on certain types of distributions. Knowing these expenses can help you prepare and minimize how much you pay.

Income Taxes

You owe income taxes on distributions from traditional IRAs and employer-sponsored plans, but your total taxes depend on your income tax bracket. It’s possible to pay the bare minimum by keeping your distributions within the lowest tax bracket. A lump-sum distribution typically incurs the most taxes since the distribution can put you into a higher tax bracket. Tax brackets are different for single people who file alone and married couples who file jointly. 

Early Withdrawal Penalty

If you withdraw from a retirement account before turning 59 ½ years old, you can incur a 10% penalty. Exceptions apply for certain expenses, and you still have to pay the income tax for a traditional IRA or employer-sponsored plan.

Roth IRA Penalty

You won’t have to worry about taxes on qualified Roth distributions. Since these accounts are funded with after-tax contributions, the proceeds are tax-free, including capital gains.

RMD Penalties

An RMD occurs if you have not made a withdrawal before turning 73. If you still do not withdraw, you will incur a penalty. This penalty is typically 50% of the amount that should have been withdrawn. It’s important to stay on top of RMD rules so you avoid significant penalties.

Saving Up for Retirement

Retirement savings make life after work more manageable. Having a steady stream of income after years of employment creates financial ease and gives you more choices in life. Creating a plan for retirement distributions and knowing about taxes and penalties can help you safeguard more of your hard-earned money.

Frequently Asked Questions