Over your working life, you have diligently salted away money into a 401(k),
403(b), SEP-IRA, SIMPLE-IRA, profit-sharing plan, IRA, Roth IRA or any
one of a number of other frequently used retirement plans. Like the ant
in the fable, you have been preparing for the day you knew would come.
If you are 70½ years old, that day is here. So is the IRS. “What
could they possibly want?” you ask. Well, you know what they ultimately
want….income taxes. Beginning with the year you reach age 70½,
the IRS requires you to withdraw a minimum amount (known as Required Minimum
Distribution or RMD) of money from your retirement plan(s) every year.
These withdrawals create taxable income so the IRS is happy.
As with all IRS rules mentioned in this article, there are exceptions.
Roth IRAs are the exception here. RMDs are not required if you have a
Roth IRA. Also, if you meet certain requirements, withdrawals from Roth
IRAs are tax-free. Neither of these exceptions makes Roth IRAs better
than other types of retirement plans. They just make Roth IRAs different.
The exception to the exception must be noted. Inherited Roth IRAs are
different, and RMDs must be made annually.
Life used to be simpler. Between 59½ and 70½ years of age,
you could withdraw or not withdraw from your retirement accounts. Taxes,
in most cases, had to be paid on any withdrawals made and you were free
to take as little or as much as you wanted without fear of IRS penalties.
Once you reach 70½ years of age, things change.
RMDs require some calculations to arrive at the minimum amount, and the
financial institution holding your retirement account assets is required
to do the math for you. However, defaulting to their amount precludes
you from doing any tax planning. How is the annual minimum required amount
determined? You need to know a few things:
- The date you turn 70½ years old
- The value of your account on December 31 of the year before you turn 70½
- Your life expectancy
The IRS provides a table (Table III) to determine life expectancy. It is a joint life expectancy table that
assumes a 10-year age difference for a couple. Both married couples and
unmarried individuals use the same table. Determine the oldest age you
will be in the year of distribution (either 70 or 71) and find the corresponding
life expectancy in the table. Divide the life expectancy into the previous
year’s December 31 value, and the result is your RMD for that year.
These steps are repeated every year until you pass away.
Once you pass away, things can get quite complicated. To leave your heirs
with as much of the account as possible and the IRS (and possibly the
probate court) with as little as possible, here are some must-do actions:
- On a regular basis, verify your beneficiary designations are up-to-date.
If at all possible, avoid naming your estate as the primary beneficiary
of your retirement account. (Your estate
will be the default if you do
not name a beneficiary.)
- If appropriate, name your children or near relatives as beneficiaries and
not your living trust. (Depending on your circumstances, it may be appropriate
to name your living trust as the primary beneficiary. Consult with your
- To take advantage of stretch options for distributions over the lifetime
of beneficiaries, special requirements apply, so be sure to consult with
your trust attorney regarding this arrangement.
In most cases, kids inherit retirement accounts. Unless these children
are well grounded, have some financial sophistication and are well on
their way to providing for their own financial future, they will more
than likely fall prey to a condition known as sudden wealth syndrome.
You’ve undoubtedly heard stories about entertainers or professional
athletes becoming broke because they lacked common sense when it came
to handling money. It is difficult to control or direct from the grave,
but there are things that can be done to increase the odds of the money
being put to best use and not squandered.
- Consider the use of a “see through” trust or, if you already
have a trust, make sure it has “see through” provisions, so
the ability to stretch distributions over a beneficiary’s lifetime
- Consider transferring your retirement accounts to a “Trusteed IRA”.
The IRS allows IRAs to be created as trust accounts or custodial accounts.
- Creditor risk may be a consideration as inherited IRAs are not creditor
protected in federal bankruptcy court.
Be sure to consult with your trust attorney for more explanation on these
options. Older is hopefully wiser and advance planning is important regardless
of age. Planning to reduce taxes on RMDs while you’re alive is obviously
worthwhile, and planning on behalf of your children is usually a good idea.
For additional financial health information, please attend Torrance Memorial's
Financial Health Seminars.
Phillip Cook, CFP® is a Certified Financial Planner in Manhattan Beach and a member of Torrance
Memorial’s Professional Advisory Council.
www.philcookadvisors.com. (310) 545-6700.