Here’s What You Need to Know Before Withdrawing Money From Your IRA

Before you take money out of your IRA, make sure you understand what’s expected of you.

One of the key pieces to retirement planning is understanding when and how much you can withdraw from your account.

Your individual retirement account comes with rules about when you can withdraw money and how much you must withdraw each year. Understanding IRA withdrawal rules is vital if you want to avoid paying penalties.

Why Are There IRA Withdrawal Rules?

It’s your money, so why are there rules about withdrawing from an IRA?

The government offers you a tax benefit when you invest using an IRA. As a result, the government expects you to use this tax-advantaged money for its intended purpose — retirement — and sets rules accordingly.

When you break the IRA withdrawal rules, you are subject to a penalty. This penalty can be hefty, depending on the circumstances. Additionally, the penalty depends on the type of IRA you have. There are slightly different rules for traditional and Roth IRA accounts. (You can learn about the differences between traditional and Roth IRAs here.)

Before you take money out of your IRA, make sure you understand what’s expected of you.

Traditional IRA Withdrawal Rules

The rules for withdrawing from a traditional IRA are more stringent than those for a Roth IRA. When you contribute to a traditional IRA, the money is pre-tax, meaning you get a tax deduction for your contributions. (Here’s a quick guide to common tax deductions.)

As a result — except for specific circumstances — the IRS expects you to keep your money in the account for a long period of time.

Withdrawing From an IRA Before Age 59½

If you take money out of your traditional IRA before you reach age 59½, you are subject to a 10% penalty. That penalty is on top of the federal and state income taxes you owe on the withdrawal.

There are exceptions to this rule. You can avoid the penalty if you withdraw the money for the following reasons:

  • Buying a home for the first time
  • Disability
  • Qualified education expenses
  • Health insurance (if you are unemployed)
  • Medical expenses that weren’t reimbursed

If you go this route, talk to a tax professional and use IRS Form 5329 to ensure you aren’t penalized.

Regular Retirement Withdrawals

During your “regular” retirement years, which start at age 59½, you can take money from your retirement account to cover any expenses you have. Though you won’t face penalties, you will be taxed at your marginal rate for withdrawals since they are considered part of your income.

Withdrawing From an IRA at Age 70½

Once you reach age 70½, you must take withdrawals from your traditional IRA. Up until this age, you aren’t required to take money out of your IRA if you don’t want to. However, at age 70½, you must take the required minimum distribution (RMD).

Your RMDs are based on a formula that takes into account the amount in your IRA and your life expectancy. If you don’t take the required amount, you will face a penalty of 50% of the amount you should have withdrawn.

Consult with a financial professional to help you figure out the best way to withdraw money from your IRA between age 59½ and 70½ to reduce the pain caused by RMD. A financial professional can help you create a plan that also takes into account the impact of Social Security benefits. Coordinate your benefits and plan withdrawals for best results.

Roth IRA Withdrawal Rules

Roth IRA withdrawal rules are a little different. Because you contribute after-tax dollars to this account, reaping no immediate benefit, some of the rules are more flexible. However, you still need to be aware of potential pitfalls and penalties.

Withdrawing From Your Roth IRA

With this type of account, it’s important to make the distinction between your contributions and your earnings.

Say you invest $5,000 in your Roth IRA each year for two years. During that time, your account grows to $16,000. In this case, your contributions total $10,000 and your earnings come to $6,000.

You can withdraw your original contributions anytime without tax or penalty. This is the money you put in after-tax, and you can use it to pay for anything.

Once you start dipping into your earnings, however, you’ll face extra charges. Tap into the earnings from your Roth IRA before you reach age 59½ and you’ll pay a 10% penalty. Plus, an early withdrawal could be subject to tax — something you normally don’t pay on Roth IRA earnings if you withdraw after age 59½.

One nice bonus of a Roth IRA? There are no RMDs associated with this account type. It doesn’t matter how old you are — you will never be forced to take money out of your Roth.

The Five-Year Rule

You need to be aware of the five-year rule with your Roth IRA. This regulation states that initial contributions to your Roth IRA must be made at least five years before you start withdrawing earnings.

Say you’re 57 when you start contributing to a Roth IRA. In that case, you can’t actually start withdrawing your earnings at age 59½ without triggering a penalty — since the five years hasn’t been met. You need to wait until you are at least 62 to satisfy the rule.

In the end, IRA withdrawal rules are fairly straightforward. If you have questions, consult a tax professional before you take money from your IRA. That way, you have a plan in place.

Image: Tom Merton

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Can I Still Contribute to an IRA & Get a Tax Break for 2016?

Can you contribute to your IRA and still get a tax break? Here's what you need to know.

Individual Retirement Accounts (IRAs) are an excellent means to save for retirement. You have until the tax-filing deadline (generally April 15) to make a contribution to your IRA for the previous tax year.

There are two types of IRAs: Traditional IRA and Roth IRA. The maximum contribution is the lesser of $5,500 ($6,500 for those aged 50 and over) or your earned income. This is a combined limit for all IRA contributions in a year (in either or both types). In order to contribute to a Traditional IRA, you must be under age 70½, but you can contribute to a Roth IRA at any age. You can learn more about IRAs here.

Whether you can contribute to an IRA and how much you can contribute depends primarily upon two factors: 1) your Modified Adjusted Gross Income and 2) whether you (or your spouse) participate in an employer-sponsored retirement plan.

Adjusted Gross Income (AGI) is the number listed on line 37 at the bottom of the first page of your Form 1040. In order to determine IRA contribution limits, AGI must be adjusted by adding back certain items that were deducted to arrive at AGI. Items added back to AGI include deductions taken for traditional IRA contributions, student loan interest, college tuition and fees, and some other less common items. The final result is Modified Adjusted Gross Income (MAGI).

Here’s how to know if you can deduct your IRA contributions this year.

Traditional IRA

While anyone under age 70½ with earned income can make non-deductible contributions to a Traditional IRA, deductible contributions are not as certain. If you are single and not covered by a plan at work or you are married and neither you (nor your spouse) have a plan at work, then your full contribution up to the annual limit is deductible.

However, if either you (or your spouse) participate in an employer retirement plan, your deductible IRA contributions may be limited or even completely eliminated. To determine if you are covered by work, you can look at your W-2. If there is a check next to “Retirement Plan” in Box 13, then you are covered. This chart on the IRS website illustrates deduction limits for both single and married taxpayers covered under an employer’s plan at work.

Roth IRA

While there are no age restrictions on who can contribute to a Roth IRA, there are income constraints that must be observed. Unlike Traditional IRA rules, Roth IRA regulations do not consider whether you have an employer plan. The only factor is your MAGI. Again, you can find the chart showing the income levels that affect Roth IRA contribution limits on the IRS’ website.

Kay Bailey Hutchison Spousal IRA

A Spousal IRA is not a third type of IRA but a provision for spouses without enough earned income to fully fund a Traditional or Roth IRA on their own. Named for the former United States Senator from Texas, the Kay Bailey Hutchison Spousal IRA allows a spouse with little or no earned income to have his or her own IRA account by qualifying with the working spouse’s income.

The Spousal IRA limits are the same as the Traditional and Roth limits ($5,500 or $6,500 if aged 50 or over). So the total combined contributions for both spouses are $11,000 or $13,000, if aged 50 or over. The working spouse must have earned enough money to fund both contributions.

Saving for retirement is more important than ever. (You can see if you have enough shored up here and keep tabs on your finances by viewing two of your credit scores, with updates every two weeks, on Credit.com.) If you don’t have a retirement plan, it’s never too late to start one. But knowing the rules is a critical step for a successful plan. Tax laws are complicated, and penalties for mistakes can be costly. Make sure you seek out the guidance of a tax professional before making important financial decisions.

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Guide to Choosing the Right IRA: Traditional or Roth?

The Roth IRA versus traditional IRA debate has raged on for years.

What many retirement savers may not know is that most of the debate about whether it’s better to contribute to a traditional IRA or a Roth IRA is flawed.

You’ve probably heard that young investors are better off contributing to a Roth IRA because they’ll likely be in a higher tax bracket when they’re older. You’ve probably also heard that if you’re in the same tax bracket now and in retirement, a traditional IRA and Roth IRA will produce the same result.

These arguments are part of the conventional wisdom upon which many people make their decisions, and yet each misses some important nuance and, in some cases, is downright incorrect.

The Biggest Difference Between Traditional and Roth IRAs

There are several differences between traditional and Roth IRAs, and we’ll get into many of them below.

The key difference is in the tax breaks they offer.

Contributions to a traditional IRA are not taxed up front. They are tax-deductible, meaning they decrease your taxable income for the year in which you make the contribution. The money grows tax-free inside the account. However, your withdrawals in retirement are treated as taxable income.

Contributions to a Roth IRA are taxed up front at your current income tax rate. The money grows tax-free while inside the account. And when you make withdrawals in retirement, those withdrawals are not taxed.

Whether it’s better to get the tax break when you make the contribution or when you withdraw it in retirement is the centerpiece of the traditional vs. Roth IRA debate, and it’s also where a lot of people use some faulty logic.

We’ll debunk the conventional wisdom in just a bit, but first we need to take a very quick detour to understand a couple of key tax concepts.

The Important Difference Between Marginal and Effective Tax Rates

Don’t worry. We’re not going too far into the tax weeds here. But there’s a key point that’s important to understand if you’re going to make a true comparison between traditional and Roth IRAs, and that’s the difference between your marginal tax rate and your effective tax rate.

When people talk about tax rates, they’re typically referring to your marginal tax rate. This is the tax rate you pay on your last dollar of income, and it’s the same as your current tax bracket. For example, if you’re in the 15% tax bracket, you have a 15% marginal tax rate, and you’ll owe 15 cents in taxes on the next dollar you earn.

Your effective tax rate, however, divides your total tax bill by your total income to calculate your average tax rate across every dollar you earned.

And these tax rates are different because of our progressive federal income tax, which taxes different dollars at different rates. For example, someone in the 15% tax bracket actually pays 0% on some of their income, 10% on some of their income, and 15% on the rest of their income. Which means that their total tax bill is actually less than 15% of their total income.

For a simple example, a 32-year-old couple making $65,000 per year with one child will likely fall in the 15% tax bracket. That’s their marginal tax rate.

But after factoring in our progressive tax code and various tax breaks like the standard deduction and personal exemptions, they will only actually pay a total of $4,114 in taxes, making their effective tax rate just 6.33% (calculated using TurboTax’s TaxCaster).

As you can see, the couple’s effective tax rate is much lower than their marginal tax rate. And that’s almost always the case, no matter what your situation.

Keep that in mind as we move forward.

Why the Conventional Traditional vs. Roth IRA Wisdom Is Wrong

Most of the discussion around traditional and Roth IRAs focuses on your marginal tax rate. The logic says that if your marginal tax rate is higher now than it will be in retirement, the traditional IRA is the way to go. If it will be higher in retirement, the Roth IRA is the way to go. If your marginal tax rate will be the same in retirement as it is now, you’ll get the same result whether you contribute to a traditional IRA or a Roth IRA.

By this conventional wisdom, the Roth IRA typically comes out ahead for younger investors who plan on increasing their income over time and therefore moving into a higher tax bracket or at least staying in the same tax bracket.

But that conventional wisdom is flawed.

When you’re torn between contributing to a traditional or Roth IRA, it’s almost always better to compare your marginal tax rate today to your effective rate in retirement, for two reasons:

  1. Your traditional IRA contributions will likely provide a tax break at or near your marginal tax rate. This is because federal tax brackets typically span tens of thousands of dollars, while your IRA contributions max out at $5,500 for an individual or $11,000 for a couple. So it’s unlikely that your traditional IRA contribution will move you into a lower tax bracket, and even if it does, it will likely be only a small part of your contribution.
  2. Your traditional IRA withdrawals, on the other hand, are very likely to span multiple tax brackets given that you will likely be withdrawing tens of thousands of dollars per year. Given that reality, your effective tax rate is a more accurate representation of the tax cost of those withdrawals in retirement.

And when you look at it this way, comparing your marginal tax rate today to your effective tax rate in the future, the traditional IRA starts to look a lot more attractive.

Let’s run the numbers with a case study.

A Case Study: Should Mark and Jane Contribute to a Traditional IRA or a Roth IRA?

Mark and Jane are 32, married, and have a 2-year-old child. They currently make $65,000 per year combined, putting them squarely in the 15% tax bracket.

They’re ready to save for retirement, and they’re trying to decide between a traditional IRA and a Roth IRA. They’ve figured out that they can afford to make either of the following annual contributions:

  • $11,000 to a traditional IRA, which is the annual maximum.
  • $9,350 to a Roth IRA, which is that same $11,000 contribution after the 15% tax cost is taken out. (Since Roth IRA contributions are nondeductible, factoring taxes into the contribution is the right way to properly compare equivalent after-tax contributions to each account.)

So the big question is this: Which account, the traditional IRA or Roth IRA, will give them more income in retirement?

Using conventional wisdom, they would probably contribute to the Roth IRA. After all, they’re young and in a relatively low tax bracket.

But Mark and Jane are curious people, so they decided to run the numbers themselves. Here are the assumptions they made in order to do that:

  • They will continue working until age 67 (full Social Security retirement age).
  • They will continue making $65,000 per year, adjusted for inflation.
  • They will receive $26,964 per year in Social Security income starting at age 67 (estimated here).
  • They will receive an inflation-adjusted investment return of 5% per year (7% return minus 2% inflation).
  • At retirement, they will withdraw 4% of their final IRA balance per year to supplement their Social Security income (based on the 4% safe withdrawal rate).
  • They will file taxes jointly every year, both now and in retirement.

You can see all the details laid out in a spreadsheet here, but here’s the bottom line:

  • The Roth IRA will provide Mark and Jane with $35,469 in annual tax-free income on top of their Social Security income.
  • The traditional IRA will provide $37,544 in annual after-tax income on top of their Social Security income. That’s after paying $4,184 in taxes on their $41,728 withdrawal, calculating using TurboTax’s TaxCaster.

In other words, the traditional IRA will provide an extra $2,075 in annual income for Mark and Jane in retirement.

That’s a nice vacation, a whole bunch of date nights, gifts for the grandkids, or simply extra money that might be needed to cover necessary expenses.

It’s worth noting that using the assumptions above, Mark and Jane are in the 15% tax bracket both now and in retirement. According to the conventional wisdom, a traditional IRA and Roth IRA should provide the same result.

But they don’t, and the reason has everything to do with the difference between marginal tax rates and effective tax rates.

Right now, their contributions to the traditional IRA get them a 15% tax break, meaning they can contribute 15% more to a traditional IRA than they can to a Roth IRA without affecting their budget in any way.

But in retirement, the effective tax rate on their traditional IRA withdrawals is only 10%. Due again to a combination of our progressive tax code and tax breaks like the standard deduction and personal exemptions, some of it isn’t taxed, some of it is taxed at 10%, and only a portion of it is taxed at 15%.

That 5% difference between now and later is why they end up with more money from a traditional IRA than a Roth IRA.

And it’s that same unconventional wisdom that can give you more retirement income as well if you plan smartly.

5 Good Reasons to Use a Roth IRA

The main takeaway from everything above is that the conventional traditional versus Roth IRA wisdom is wrong. Comparing marginal tax rates typically underestimates the value of a traditional IRA.

Of course, the Roth IRA is still a great account, and there are plenty of situations in which it makes sense to use it. I have a Roth IRA myself, and I’m very happy with it.

So here are five good reasons to use a Roth IRA.

1. You Might Contribute More to a Roth IRA

Our case study above assumes that you would make equivalent after-tax contributions to each account. That is, if you’re in the 15% tax bracket, you would contribute 15% less to a Roth IRA than to a traditional IRA because of the tax cost.

That’s technically the right way to make the comparison, but it’s not the way most people think.

There’s a good chance that you have a certain amount of money you want to contribute and that you would make that same contribution to either a traditional IRA or a Roth IRA. Maybe you want to max out your contribution and the only question is which account to use.

If that’s the case, a Roth IRA will come out ahead every time simply because that money will never be taxed again.

2. Backdoor Roth IRA

If you make too much to either contribute to a Roth IRA or deduct contributions to a traditional IRA, you still might be eligible to do what’s called a backdoor Roth IRA.

If so, it’s a great way to give yourself some extra tax-free income in retirement, and you can only do it with a Roth IRA.

3. You Might Have Other Income

Social Security income was already factored into the example above. But any additional income, such as pension income, would increase the cost of those traditional IRA withdrawals in retirement by increasing both the marginal and effective tax rate.

Depending on your other income sources, the tax-free nature of a Roth IRA may be helpful.

4. Tax Diversification

You can make the most reasonable assumptions in the world, but the reality is that there’s no way to know what your situation will look like 30-plus years down the road.

We encourage people to diversify their investments because it reduces the risk that any one bad company could bring down your entire portfolio. Similarly, diversifying your retirement accounts can reduce the risk that a change in circumstances would result in you drastically overpaying in taxes.

Having some money in a Roth IRA and some money in a traditional IRA or 401(k) could give you room to adapt to changing tax circumstances in retirement by giving you some taxable money and some tax-free money.

5. Financial Flexibility

Roth IRAs are extremely flexible accounts that can be used for a variety of financial goals throughout your lifetime.

One reason for this is that your contributions are available at any time and for any reason, without tax or penalty. Ideally you would be able to keep the money in your account to grow for retirement, but it could be used to buy a house, start a business, or simply in case of emergency.

Roth IRAs also have some special characteristics that can make them effective college savings accounts, and as of now Roth IRAs are not subject to required minimum distributions in retirement, though that could certainly change.

All in all, Roth IRAs are more flexible than traditional IRAs in terms of using the money for nonretirement purposes.

3 Good Reasons to Use a Traditional IRA

People love the Roth IRA because it gives you tax-free money in retirement, but, as we saw in the case study above, that doesn’t always result in more retirement income. Even factoring in taxes, and even in situations where you might not expect it, the traditional IRA often comes out ahead.

And the truth is that there are even MORE tax advantages to the traditional IRA than what we discussed earlier. Here are three of the biggest.

1. You Can Convert to a Roth IRA at Any Time

One of the downsides of contributing to a Roth IRA is that you lock in the tax cost at the point of contribution. There’s no getting that money back.

On the other hand, contributing to a traditional IRA gives you the tax break now while also preserving your ability to convert some or all of that money to a Roth IRA at your convenience, giving you more control over when and how you take the tax hit.

For example, let’s say that you contribute to a traditional IRA this year, and then a few years down the line either you or your spouse decides to stay home with the kids, or start a business, or change careers. Any of those decisions could lead to a significant reduction in income, which might be a perfect opportunity to convert some or all of your traditional IRA money to a Roth IRA.

The amount you convert will count as taxable income, but because you’re temporarily in a lower tax bracket you’ll receive a smaller tax bill.

You can get pretty fancy with this if you want. Brandon from the Mad Fientist, has explained how to build a Roth IRA Conversion Ladder to fund early retirement. Financial planner Michael Kitces has demonstrated how to use partial conversions and recharacterizations to optimize your tax cost.

Of course, there are downsides to this strategy as well. Primarily there’s the fact that taxes are complicated, and you could unknowingly cost yourself a lot of money if you’re not careful. And unlike direct contributions to a Roth IRA, you have to wait five years before you’re able to withdraw the money you’ve converted without penalty. It’s typically best to speak to a tax professional or financial planner before converting to a Roth IRA.

But the overall point is that contributing to a traditional IRA now gives you greater ability to control your tax spending both now and in the future. You may be able to save yourself a lot of money by converting to a Roth IRA sometime in the future rather than contributing to it directly today.

2. You Could Avoid or Reduce State Income Tax

Traditional IRA contributions are deductible for state income tax purposes as well as federal income tax purposes. That wasn’t factored into the case study above, but there are situations in which this can significantly increase the benefit of a traditional IRA.

First, if you live in a state with a progressive income tax code, you may get a boost from the difference in marginal and effective tax rates just like with federal income taxes. While your contributions today may be deductible at the margin, your future withdrawals may at least partially be taxed at lower rates.

Second, it’s possible that you could eventually move to a state with either lower state income tax rates or no income tax at all. If so, you could save money on the difference between your current and future tax rates, and possibly avoid state income taxes altogether. Of course, if you move to a state with higher income taxes, you may end up losing money on the difference.

3. It Helps You Gain Eligibility for Tax Breaks

Contributing to a traditional IRA lowers what’s called your adjusted gross income (AGI), which is why you end up paying less income tax.

But there are a number of other tax breaks that rely on your AGI to determine eligibility, and by contributing to a traditional IRA you lower your AGI you make it more likely to qualify for those tax breaks.

Here’s a sample of common tax breaks that rely on AGI:

  • Saver’s credit – Provides a tax credit for people who make contributions to a qualified retirement plan and make under a certain level of AGI. For 2017, the maximum credit is $2,000 for individuals and $4,000 for couples.
  • Child and dependent care credit – Provides a credit of up to $2,100 for expenses related to the care of children and other dependents, though the amount decreases as your AGI increases. Parents with young children in child care are the most common recipients of this credit.
  • Medical expense deduction – Medical expenses that exceed 10% of your AGI are deductible. The lower your AGI, the more likely you are to qualify for this deduction.
  • 0% dividend and capital gains tax rate – If you’re in the 15% income tax bracket or below, any dividends and long-term capital gains you earn during the year are not taxed. Lowering your AGI could move you into this lower tax bracket.

Making a Smarter Decision

There’s a lot more to the traditional vs. Roth IRA debate than the conventional wisdom would have you believe. And the truth is that the more you dive in, the more you realize just how powerful the traditional IRA is.

That’s not to say that you should never use a Roth IRA. It’s a fantastic account, and it certainly has its place. It’s just that the tax breaks a traditional IRA offers are often understated.

It’s also important to recognize that every situation is different and that it’s impossible to know ahead of time which account will come out ahead. There are too many variables and too many unknowns to say for sure.

But with the information above, you should be able to make a smarter choice that makes it a little bit easier to reach retirement sooner and with more money.

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What Your Family Needs to Know About Your IRA Distributions

ira-distribution-after-death

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.

Image: Martinan

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5 Things You Must Know About Lifetime IRA Distributions

ira-distributions-rules

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.

[Editor’s Note: Saving for retirement is an important part of any financial plan, and so is improving your credit. You can monitor your financial goals, like building a good credit score, each month on Credit.com.]

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