Millions of Americans take advantage of the tax-deferred vehicles offered by the tax code in order to save wisely for their future. These plans include 401(k) and 403B plans and individual retirement accounts or IRA’s. Individuals can save pretax into these tax-deferred retirement savings accounts and the money can grow tax-free. However most realize that this is not a permanent tax holiday.
The US government wants to get its share eventually. That time is when an individual hits the magical age of 70 1/2 years old. Why a half-year you ask? Another brilliant move by Congress.
What happens once you have reached this age? You are required to take withdrawals from these accounts so that the government can tax the withdrawals. Often people state that they do not need the money, but the government requires the withdrawal in order to generate tax revenue.
The term used for these withdrawals is ‘required minimum distributions’ or RMD’s. It pays to properly calculate the RMD as the Internal Revenue Service is gearing up to increase scrutiny of the IRA errors including inadequate withdrawals.
Here are some things to consider when calculating your minimum distribution.
Multiple accounts: if you are fortunate enough to have several tax-deferred accounts such as a couple of IRAs, you need to sum up all of the accounts in order to determine the amount of the distribution. You are able to take the full amount for all of the accounts from just one account as long as it equals the amount for all of the accounts.
If you have several 401(k) accounts from previous employers, you have to take a distribution from each of those accounts. It is one of the reasons you should seriously contemplate combining your entire tax-deferred like titled accounts into one account.
How much do I need to withdraw? The account balances at the close of business December 31 in the previous year are used to calculate the required amount. There are complications to the calculation but generally the brokerage firms will notify the owner of the amount they must withdraw that year based on Internal Revenue Service tables. As a general rule, the percentage will begin at age 71 at approximately 4% and grow over time slowly each year as the owner ages. The idea behind this increasing percentage is that this account will be fully taxed over the lifetime of the person.
As an example, if an owner was 73 years old and her spouse was 75 years old and her IRA account balance at end of the previous year was $500,000, she would be required to take $20,243 out of the IRAs or 4.22% of the total. This withdrawal is considered income and taxed at the person’s income tax rate depending on their individual tax situation. (As you can see by my detailed description above, there are some complications for married owners who spouses are more than 10 years younger.)
If the net proceeds are not needed for income, this amount can be added to a taxable account and invested without the tax-deferred treatment.
How do I generate the cash for the RMD? The withdrawal is required to be paid out from a tax deferred account. Depending on the structure of the portfolio, the investments inside the account may need to be sold in order to generate the cash needed to make the withdrawal.
Some other items to consider for the IRA accounts:
Make sure you review the account beneficiary information, as the stated beneficiary will receive the amount regardless of what is in your will. These can be very valuable for younger individuals as the IRA has the potential to become a stretch IRA. A stretch IRA is an estate planning concept used to extend the financial life of an IRA over multiple generations. The strategy lets an IRA’s orginal beneficiary transfer, upon death, the IRA assets to the beneficiary without triggering an immediate tax liability.
For married couples, upon the death of the first spouse, you are able to combine the deceased spouses IRA with your own IRA and continue to make distributions with the higher principal amount.
For 2013, you can transfer all or part of your required withdrawal amount, up to $100,000, to a charity of your choosing and avoid the income tax on the amount you contribute. This applies only for IRAs and does NOT apply to 401(k)s, 403(b)s and other retirement plans.
As with most tax considerations, it is always best to work with a tax advisor and keep careful records just as you do with your charitable contributions. Your financial advisor will also be a good source of information on handling these required minimum distributions.
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