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Interview: Ed Slott

Develop Your Exit Strategy

Ed Slott

Ed Slott is a nationally recognized IRA distribution expert and a professional speaker. He was named as the best source for IRA advice by The Wall Street Journal and called "America's IRA Expert" by Mutual Funds Magazine. He is the author of Your Complete Retirement Planning Roadmap. This is an edited transcript of an interview conducted on August 29, 2007.

"Most people don't realize it, but they are on track to give most of their hard-earned savings right back to the government. It is the way you take it out that will determine how much you keep."

Can you explain the difference between a 401(k) and an IRA, and how they differ when it comes to drawing down money from them?

A 401(k) is a company-sponsored plan. It may be your money, but it is not your plan. It is run by the rules of the company, so you may not be able to take your money out whenever you like, or there are certain triggering events in the plan that allow you to take out money – reaching a certain age, separation from service. An IRA, on the other hand, is your money and your plan. You can take money out of an IRA any time you wish. There may be penalties, for example, if you take it out before 59-1/2, but you can always access your own money in an IRA.

I equate the whole retirement area to a football game. There is the first half when you accumulate the money, that is the accumulation phase – and the second half, which is the distribution phase. I like to call it the exit strategy. The game is won or lost in the second half. Because it is the way you take the money out that will determine how much you keep and how much goes to the government. Most people don't realize it, but they are on track to give most of their hard-earned savings right back to the government. It is the way you take it out that will determine how much you keep.

What kind of taxation can we expect if we draw down our 401(k) money too soon?

Regardless of whether you withdraw from an IRA or a 401(k), there are overriding tax rules from the U.S. Tax Code that say certain withdrawals are too early. You may have to pay a 10% penalty. Once you hit age 59-1/2, you can generally withdraw from anywhere without a penalty. You will still pay the tax, but not the penalty. In a 401(k) there is a special rule that does not apply to IRAs. If you happen to separate from service, retire, quit, resign, get fired, it doesn't matter… if you leave the company in the year you turn age 55 or older, you can withdraw your money from the plan, penalty free. So in that case you might want to leave your money in the plan if you think you are going to need money between 55 and 59-1/2. When you hit 59-1/2, you can roll it over to an IRA where you can withdraw penalty-free on your own schedule.

Don't I have to withdraw a certain amount of money from the 401(k) on an annual basis at the age of 70-1/2?

If you are between 59-1/2 and 70-1/2, you can't make a mistake. Whatever you want to do there can not be a penalty. Before 59-1/2 there is a 10% penalty for withdrawing early in addition to the tax. After 70-1/2 there are required distribution rules. That is the time that our government has decided they are just sick and tired of waiting for you to drop dead and they want their money back. If you don't take that money out on time, it is a 50% penalty on the amount you should have withdrawn but didn't. That kind of penalty can consume a retirement account very quickly. There are a lot of people who are over 70-1/2 who don't know about these things. The rules say that wherever you have your money – an IRA custodian, a bank, broker, mutual fund company, insurance company – once you are 70-1/2 they are required to notify you in writing that you have a required distribution.

How many years do I have to withdraw my 401(k) money when I am 70-1/2 years old?

Once your required distributions begin, they are based on an actuarial life expectancy, and the IRS publishes tables on that. You can find the tables in IRS Publication 590 on the IRS website, or at my web site irahelp.com. It is called the Uniform Lifetime Table. You look up your age for each year and they give you a factor, and you divide by that factor. So if the factor is, say 20 years, you have to take out 1/20th of your IRA funds that year, or 5%.

What is a rollover, and why would I want to do that?

A rollover means moving money from one plan to another. The most common type of rollover is when you take money out of your 401(k) upon you retirement and you move it to an IRA. You could be moving money from one IRA to another, or an IRA to a company plan, or a company plan to another company plan. You have to be very careful when you move tax sheltered money, and this is an area where people are making huge mistakes. I know it sounds easy, but you have only 60 days to do it. Apparently for most people, it isn't enough time. They are thinking about where to invest it, all kinds of other issues. Meanwhile, they are holding onto the money while the clock is ticking.

What kinds of rollovers are there?

There are two kinds of rollovers. One is called a direct rollover where it goes right from one plan to another without you touching the money in between. That is the best way to move money. The other rollover is the regular rollover. It has all kinds of bad things that can happen, because the company gives you a check, so you are in control of the money now, and you only have 60 days to put it into a plan. If it comes from a company plan and you do a regular rollover, they have to deduct 20% withholding tax, so you only really get 80% of your money, and they are withholding the other 20%, which you will get back when you file your taxes. You may not have enough money to complete the rollover, and could end up in a taxable situation. Also, with a regular rollover, you can only do one of them every twelve months. For the direct rollover, none of these problems exist. That's the best way to move money, where you never touch it.

What is the difference between a traditional 401(k) or IRA and a Roth?

The traditional 401(k) is a vehicle where you put money in and you get a tax deduction on it. But when you take it out, it is all taxable, plus the earnings. So to me that is really a trap for the future. With a Roth, it is the other way around. You put the money in and you don't get a tax deduction up front, which costs you a little more, but the big back end is that you get a windfall tax-free for the rest of your life. The last thing on Earth you want in retirement is to have to pay taxes on the money you are pulling out. And because you will have already paid the taxes up front, you avoid the risk of tax rates going up. I believe tax rates will go through the roof because of several impending financial crisis involving Social Security, Medicare and pension. If you have a few hundred thousand in a Roth IRA, that is really worth twice as much as a fund with traditional money, half of which could go to the government.

Are there any other benefits to a Roth?

Another huge benefit that most people are not aware of is that when you save in a Roth, unlike a traditional IRA, during your life there is no required distribution. In other words at 70-1/2 if you don't need the money, it can still keep growing tax-free, and that is how people can build huge tax-free fortunes in their lifetime. When they die, they can pass the Roth IRA down to children or grandchildren or another beneficiary, and it will be tax-free. So not only is it tax-free for your entire lifetime, you have just provided your children or possibly grandchildren with a legacy of money coming out every year tax-free for the rest of their lives.

Do most financial professionals offer advice regarding tax advantages?

The average advisor is not that well trained in how to get the money out and take advantage of these great tax benefits. So you have to work with an advisor who has specialized expertise in the distribution end. They are trained mostly in investments, how to build money. But remember – it's what you keep that counts. I don't care if you have an advisor that helped you make 30-40% a year. If you give 80% of it back during the second half of the game, all you have done is build a savings account for the government. The longer you keep it away from the government, the more money you and your family will have. I actually went out and created an elite force of advisors who are specialized in this area. There are hundreds of them all over the country and you can find them at irahelp.com.

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