Protecting Your Nest Egg From The IRS

With the introduction of the Roth IRA under the Taxpayers Relief Act of 1997. There is much hype about the possibility of creating a retirement plan from which you’ll be able to withdraw funds free of federal income taxes. Yet for many people, particularly those approaching the age of 70, rolling your traditional IRA into a Roth IRA may not be an attractive option. For these folks, understanding the rules applying to your traditional retirement account (IRA) is critically important. Failure to understand IRS’ IRA rules and properly integrating your individual retirement account planning with your overall estate planning can spell disastrous results. The reason: unpaid federal and state income taxes and the possibility of estate taxes resulting from your IRA account.

It is not unusual for individuals approaching retirement to have accumulated $200,000 or $300,000 in their IRA. I have seen IRA accounts approaching $1 million. With the current estate tax exemption at $625,000 and income taxes due on withdrawals from your IRA, careful planning is necessary to minimize the potential tax bite.

Several definitions are important:

  • “RBD” = Required Beginning Date
  • “DB” = Designated Beneficiary
  • “ALE” = Applicable Life Expectancy
  • “SRO” = Spousal Rollover
  • “P” = Participant (you)

bigstock-Irs-1388352The traditional IRA account is a tax deferred account held by a custodian for a participant subject to both federal estate and income taxes (as well as state taxes). Uncle Sam wants those taxes paid. If you are a participant in a traditional IRA arrangement (not a Roth IRA), the government wants you to begin paying the income taxes due on your IRA in the year you reach the age of 70-1/2. Your first payment can be delayed until your RBD (Required Beginning Date) which is April 1 of the year after you reach 70-1/2. But you still owe a payment for the year you reach 70-1/2, so if you wait until April 1 and you’re 71 years of age, you must take out two withdrawals and pay taxes on both.

Determining the minimum withdrawal required can be complicated. Simply stated, your minimum withdrawal required after you reach your RBD is calculated on your applicable life expectancy (“ALE”). The Internal Revenue Service gives you several options for determining your ALE. You must elect one of these options before your RBD and your election is irrevocable. If you make the wrong election or you fail to make an election at all, the results can be catastrophic.

You can withdraw your IRA funds at any time after reaching 59-1/2 and pay the income tax. Most participants want to defer paying any tax until the last possible moment. Therefore they delay distribution until their required beginning date (“RBD”). At that time, they must elect to begin withdrawals. The longer you stretch out your withdrawals, the more the account can grow tax deferred. If you make the right choices and the right election, an individual participant can theoretically stretch the withdrawals from their IRA account over their life expectancy as determined by the IRS and the life expectancy of the DB (designated beneficiary). This could produce amazing results if the DB were, for example, a grandchild who, for example, was two years old at the time the participant reached 70-1/2.

In any event, the choices you make at your RBD are very important. As you approach 70-1/2 it is extremely critical that you discuss these options with a knowledgeable financial planner or estate planning professional. If your goal is to minimize your withdrawal and maximize your tax deferral and accumulation in your IRA account after you reach your required beginning date, then you will want to calculate your withdrawal on the maximum applicable life expectancy.

You have these choices: (Click on the choice below to reveal the answer.)

You can elect to calculate your withdrawal over your own lifetime.

You can elect to withdraw your IRA over your lifetime and the lifetime of your DB (designated beneficiary). If you named more than one beneficiary to your plan (and you should check your plan immediately to make sure that you have named a beneficiary and a contingent beneficiary or beneficiaries), then the oldest beneficiary is your DB and the ALE (applicable life expectancy) would be determined based on your age and the age of the oldest beneficiary. These life expectancies are determined using a table provided by the Internal Revenue Service in IRS Publication 590 entitled “Individual Retirement Arrangements.” You will need this publication before you can make an informed election regarding withdrawals from your IRA.

In summary, it is extremely important to consider carefully your options in determining your minimum withdrawals at your required beginning date. Particularly important is the determination whether to calculate or recalculate your life expectancy for minimum distribution purposes and to determine who to name as your designated beneficiary when you reach your required beginning date. This election is irrevocable with respect to determining your minimum withdrawals. And while you can change your beneficiary at any time, your designated beneficiary at your required beginning date will determine your minimum distribution requirement regardless of whether you change the beneficiary later or not. If you are approaching the age of 70-1/2, you will need to consult with a knowledgeable professional regarding your options for determining withdrawals from your traditional IRA and incorporating your IRA planning into your overall estate planning to determine not only your income tax liability but your potential estate tax liability.

In summary, it is extremely important to consider carefully your options in determining your minimum withdrawals at your required beginning date. Particularly important is the determination whether to calculate or recalculate your life expectancy for minimum distribution purposes and to determine who to name as your designated beneficiary when you reach your required beginning date. This election is irrevocable with respect to determining your minimum withdrawals. And while you can change your beneficiary at any time, your designated beneficiary at your required beginning date will determine your minimum distribution requirement regardless of whether you change the beneficiary later or not. If you are approaching the age of 70-1/2, you will need to consult with a knowledgeable professional regarding your options for determining withdrawals from your traditional IRA and incorporating your IRA planning into your overall estate planning to determine not only your income tax liability but your potential estate tax liability.