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Planning Your IRA Withdrawals

Individual retirement accounts (IRAs) have become part of nearly everyone’s financial plans. Consequently, information about the benefits of putting money into these accounts is common. But the other side of IRAs — withdrawals — has received less attention.

Do you know when you can take penalty- free early withdrawals? And have you thought about what withdrawal strategy will work best for you during retirement? Factors such as your age, health and, in some cases, life expectancy affect your options. Let’s look at some of the rules governing IRA distributions while reflecting on how they could affect your situation.

Tax Rules for Distributions

For tax purposes, you generally must consider traditional IRA distributions as ordinary income when distributed to the recipient (you during your life or your spouse or other beneficiary after your death).

For maximum tax safety, keep in mind two key ages, 59 1/2 and 70 1/2, as you develop your IRA distribution plan because:

  •  Penalties generally apply to distributions taken before age 59 1/2; and

  •  Even greater penalties apply for failing to take minimum distributions after age 70 1/2.

Distributions Taken Before Age 59 1/2

Although you generally cannot withdraw funds from your IRA before age 59 1/2 without incurring a 10% penalty tax, this rule does have exceptions. The 10% tax does not apply to distributions:

  • Made after the IRA owner’s disability or death,

  • Taken to pay qualified higher education expenses,

  • Used for a first-time home purchase (up to $10,000),

  • Treated as a return of a nondeductible contribution, or

  • That are part of a series of substantially equal payments made beyond your life expectancy or the life expectancy of you and your beneficiary.

Rules for the life expectancy exception are strict. To use this exception, take distributions through an IRS-approved method and elect to receive at least one distribution payment annually. Payments must continue for at least five years or until you reach age 59 1/2— whichever is longer. But this five-year rule does not apply if the IRA owner becomes disabled or dies.

Distributions Taken After Age 59 1/2

Once you are older than 59 1/2 you can take distributions from your IRA in any amounts you choose. But remember, any funds distributed are taxed as income. Also, keep in mind that once funds are distributed, you lose the ability to defer the tax on future income from those funds.

To minimize your income tax, consider taking distributions in years you have relatively little taxable income or many deductible expenses, such as medical costs and charitable contributions.

Many people these days work into their late 60s or early 70s. If you plan to work beyond standard retirement age, consider putting off withdrawing IRA funds until the law requires you to begin taking minimum distributions at age 70 1/2.  This strategy maximizes your funds’ tax-deferred growth.

Distributions Taken After Age 70 ½

You must begin taking minimum distributions by April 1 of the year following the year you turn 70 1/2.  This date is known as your required beginning date (RBD). If you wait the extra year, rather than beginning when you reach age 70 1/2, you must take a double distribution the first year.

Generally, you must choose a distribution method and take minimum distributions in at least annual installments. This will involve scheduling distributions according to a chart referencing your life expectancy or the life expectancies of you and a designated beneficiary. If you designate multiple beneficiaries, IRA rules use the oldest beneficiary to determine the maximum distribution period.

Methods of Distribution

At your RBD, you must take minimum distributions according to either the recalculation method or the term certain method, whichever you prefer. Once selected, the method you choose is irrevocable and applies to all subsequent years.

The recalculation method. This is the default method for most IRA plans. With the recalculation method, you calculate a new life expectancy figure each year based on your age and a tax code formula. The formula is based on a table of joint life expectancies of you and your beneficiary. If the beneficiary is a person other than your spouse, the maximum difference in ages that can be used to calculate the joint life expectancy is 10 years.

One advantage of the recalculation method is that it stretches out the period for minimum distributions, allowing more tax-deferred growth for your funds. On the down side, if either person factored into the recalculation dies, the deceased’s life expectancy becomes zero. If this happens, payments automatically accelerate.

The term certain method. With this method, you calculate a life expectancy figure based on your RBD. For example, if your life expectancy is 20 years, you must distribute 1/20 of your account in the first year. After that, you reduce the denominator by one each year. Although the term certain method generally defers less and increases minimum distributions compared with the recalculation method, it continues using the same joint life expectancy tables to figure distributions even after one person dies.

Minimum Distributions

Whatever distribution method you use, several factors affect minimum distribution amounts. Seek professional advice and take great care to calculate minimum distributions accurately because failure to withdraw the proper amount in any year could result in a 50% excise tax on the shortfall.

To figure the minimum amount for a given year, consider all your IRA balances as of Dec. 31 of the previous year. But while you must aggregate all IRAs for purposes of computing your minimum distribution amount, you can take the distribution from any single IRA or combination of IRAs.

Beneficiary Distributions

If you die before your RBD, the general rules say that the remaining balance in the IRA must be fully distributed to a beneficiary within five years of your death. But if your benefit is payable to a nonspouse beneficiary and will be distributed throughout this person’s life, distributions must begin within one year of your death. If your spouse is the beneficiary, your IRA balance may be rolled over tax-free to his or her IRA.

If you die on or after your RBD, distributions must generally be made to the beneficiary at least as rapidly as they were being made to you according to the method used before your death.

Protect Yourself From Penalties

Taking distributions from your IRA can be complicated. The last thing you need to find out during retirement is that withdrawals you’ve been counting on will be reduced by penalties. Careful planning with your tax advisor can safeguard your IRA benefits, so call us today.

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