What Your Family Needs to Know About Your IRA Distributions

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Things become complicated upon an IRA owner’s death. If the account holder dies before his required beginning date, or RBD, there is no required minimum due for that year. If, however, the participant dies after his RBD, the beneficiaries must take his final required minimum distribution (RMD) before December 31 of the year of death. If it is not taken, the 50% penalty applies.

After the year of death, the beneficiaries now are obligated to take their own RMDs annually. While the requirement for lifetime minimum distributions is commonly recognized, many people are unaware that RMDs continue after death. If the correct RMD is not taken, the same 50% penalty is assessed on the beneficiaries.

The rules for these required distributions are determined by two broad factors:

  1.  Whether the participant had reached his RBD before death
  2. The type of beneficiary: spouse, non-spouse, trust or estate

Roth IRAs do not require lifetime RMDs. However, upon the death of a Roth IRA owner, the beneficiaries are required to take RMDs or face the same stiff 50% penalty.

Death Before the Required Beginning Date

First, we will assume that RMDs have not yet started prior to the participant’s death (he died before reaching age 70½, leaving his wife as the beneficiary). In this scenario, the spouse would have three options:

  1. Treat the IRA as her own and follow the RMD rules for her own IRA
  2. Start distributions when the participant would have turned age 70½ using her current age each year to determine the correct life expectancy factor from Table I
  3. Take any amount each year, but take the entire balance December 31 of the fifth year following the spouse’s death (known as the five-year rule)

If the goal is to defer taxes as long as possible, the five-year rule is probably not ideal since the entire account will be liquidated and all taxes paid within five years, which may be significantly shorter than the life expectancy of the beneficiary. However, if no distributions are made in the year after death, this option becomes the default.

It is important to remember that RMDs are just that: required minimum distributions. Any of the affected parties can always take out more than the minimum required. So electing an option that provides for the lowest minimum distribution offers the best planning opportunities. It provides the absolute least that must be taken without penalty, without compromising the option to take more at any time.

A non-spouse has two options if RMDs have not yet started prior to the IRA owner’s death:

  1. Distribute the balance by using the Table I factor corresponding to the beneficiary’s age on December 31 in the year following the owner’s death. Each subsequent year, she would reduce the previous year’s factor by one (rather than using the factor for the new current age each year)
  2. Assets can be distributed using the five-year rule.

The only option available to trust or estate beneficiaries when RMDs have not yet commenced is the five-year rule. The estate is automatically the presumed beneficiary if there is no beneficiary listed. So, it is critical that the participant names both a beneficiary and a contingent beneficiary in order to preserve the tax deferral available using the life expectancy option above.

Death After the Required Beginning Date

If, however, the participant had already started RMDs prior to death, a separate set of rules apply. Again, the spouse enjoys the most flexibility. Her options include:

  1. Treat the IRA as her own (like the previous scenario)
  2. Distribute the balance over her life using her current age each year to determine the factor used in Table I
  3. Distribute the account based on participant’s age as of his birthday in the year of death (if he died prior to his birthday, add one year to his age) using Table I. Then each subsequent year, reduce the previous life expectancy factor by one.

While a spouse has several options to continue pre-death RMDs, a non-spouse is left with only one option. They must use the younger of:

  1. Their age at year end following the year of the owner’s death or
  2. The owner’s age at birthday in year of death

To calculate the RMD, divide the account balance by the life expectancy factor that corresponds to that age in Table I. Each subsequent year, reduce the previous life expectancy factor by one (as opposed to looking up the new current age each year).

If multiple beneficiaries are named, it is best to establish separate accounts for each beneficiary at death so that each can utilize their own life expectancy factor. A single beneficiary account will force all of the beneficiaries to use the oldest beneficiary’s age to determine RMDs for all of them. This will force higher RMDs than necessary for the younger beneficiaries, which will accelerate taxation.

A trust or estate beneficiary has the same single option as a non-spouse, with one modification. Since a trust is not a natural person with a life expectancy, it cannot use the beneficiary’s age but is forced to use the participant’s age as of his birthday in the year of death to find the corresponding Table 1 life expectancy factor. Some Trusts can be drafted to include a “look-through provision” that names a qualified individual beneficiary or beneficiaries that qualify as individuals. However, if the estate is named, or no beneficiary is named at all, this rule applies.

In my many years as a Certified Financial Planner practitioner, I have come across situations where individuals were provided inaccurate advice from bankers, stockbrokers and even financial planners. IRA distribution planning is very complex. It requires a high level of expertise in order to make the best decisions that minimize taxes and penalties and provide the most flexibility for the individuals affected. Since the general information provided in this article is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice, I highly recommend that you consult with a Certified Public Accountant and a Certified Financial Planner professional before making any of these critical financial decisions.

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5 Things You Must Know About Lifetime IRA Distributions

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Individual Retirement Accounts, or IRAs, are wonderful retirement accumulation vehicles. Contributions are generally tax-deductible (with limitations), and the assets in the accounts grow without the burden of taxation until withdrawn. Distributions are generally taxed the same as earned income. Roth IRAs are similar to Traditional IRAs in that the account also grows free of income taxation. However, contributions are not tax-deductible and qualified distributions are generally income-tax free. For the purpose of this discussion, I will primarily focus on lifetime traditional IRA distributions.

1. There Is a 10% Penalty Tax

Since Congress designed IRAs for retirement needs, and not for pre-retirement vacations or mid-life crisis Porsches, there is a 10% penalty tax imposed on the taxable portion of withdrawals taken prior to age 59½ (with a few limited exceptions). While the pre-59½ rule limits early distributions, there is also a rule that forces distributions to be taken later in life. This rule prevents the accountholder from overusing the tax deferral provided by the plan. Generally, April 1st of the year after the accountholder turns age 70½ is the Required Beginning Date (RBD) for withdrawals. This is when the first Required Minimum Distribution (RMD) from the plan is due. An individual reaches age 70½ six months following their 70th birthday. If you turn age 70 between January 1 and June 30, you will turn 70½ during that calendar year. If your birthday is between July 1 and December 31, you will turn 70½ in the following calendar year.

2. The RMD Must Be Taken Annually

The RMD must be taken annually by December 31 each year thereafter using the year-end value of the IRA of the previous year. It is important to note that the first RMD can be taken in the actual year that the participant turns 70½. The following year’s April 1st deadline is actually sort of a first-year grace period. If the first RMD is delayed until April 1st (as opposed to taken by December 31 of the 70½ year), another RMD is due by December 31 of that same year. So it may actually make sense to take the first RMD by December 31 of the year in which the participant actually turns 70½ instead of waiting to avoid two withdrawals in the same calendar year and possibly increase taxation by potentially pushing the participant into a higher tax bracket.

3. There Is a 50% Penalty If the Accountholder Doesn’t Take the RMD

If the accountholder does not take the required minimum amount, a 50% penalty is imposed on the portion of the required amount that was not taken. That is not a typographical error. The penalty is really 50%. This penalty is in addition to the normal income tax payable on the distribution. The purpose of this Required Minimum Distribution, at least theoretically, is to liquidate the entire balance of the retirement account by the end of the participant’s lifetime. In order to do this, the IRS has developed three Life Expectancy Tables (see below). Table I applies to RMDs after the death of the participant, while Tables II and III applies to required distributions during the participant’s lifetime.

4. There’s a Specific Way to Determine the Lifetime RMD

The lifetime RMD is determined by dividing the account balance as of December 31 of the previous year by the factor on Table III of the IRS Publication 590 Life Expectancy Tables, corresponding to the age of the account owner. If, however, the sole beneficiary of the account for the entire year is a spouse who is more than 10 years younger than the participant, Table II must be used. For subsequent years, the new attained age for that year is used to determine a new RMD divisor in the same Table that was used in the first year. In other words, increase the age by one year and look up the corresponding new life expectancy factor each year.

5. Lifetime RMDs Do Not Apply to Roth IRAs

It is important to note that the lifetime RMDs generally apply to Traditional, SEP, and SIMPLE IRAs, but do not apply Roth IRAs. (The RMD rules vary somewhat for employer-sponsored retirement plans like 401Ks, 403Bs, pension plans, and government plans, which are not covered in this discussion.) If the participant owns multiple IRAs, the values must be combined to determine the correct RMD, but withdrawals can come from any or all of the accounts.

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