When must you start withdrawing the funds in your retirement plans? And what happens if the funds aren't withdrawn before you die? To what extent will your heirs be taxed? The rules are complex but there are ways the savvy taxpayer can maximize the tax shelter.
The basic rule is that you must begin withdrawing funds--and incurring taxes on these withdrawals--no later than April 1 of the year after you turn 70 ½. This rule exists so that retirement funds will be distributed whether or not spent during what for most people is their retirement years.
An exception to this general rule is that, where your retirement plan permits, you do not need to begin these mandatory withdrawals until you retire if you are still employed when you reach the mandatory withdrawal age. The exception doesn't apply where you're a 5 percent or more owner of the business that provides the plan, or to withdrawals from traditional IRAs--in those cases, you are subject to the mandatory withdrawal rules.
Preserving the tax shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution--or the smaller the amount you must withdraw the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows, to maximize assets and the shelter, for the next generation.
The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter that started out to aid your retirement.
The rules are complex, but here's a general overview of the timing of retirement plan distributions which will help avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules, professional guidance in this area is strongly suggested.
Before You Reach Age 70 ½
Until the year you reach 70 ½, you need not take your money out of your retirement account, although your employer's plan might require you to do so. In fact, there will usually be a 10 percent early-withdrawal penalty if you make withdrawals from an IRA before age 59 ½. Between the ages of 59 ½ and 70 ½ you pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax contributions you made.
Once You Reach Age 70 ½
Once you hit 70 1/2, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 70 1/2 say April 1, 2017, if you reach 70 1/2 in 2017. But waiting until April 1 means you must withdraw for two years--2017 and 2018 in 2018. To avoid this income bunching and a possible higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 70 1/2.
IRS has greatly simplified and relaxed the withdrawal rules over the years to increase the retirement plan tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.
The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your life expectancy.
Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the year.
Designating a beneficiary is no longer needed to prolong distributions during your lifetime (except where your beneficiary spouse is more than 10 years younger than you). But it's still needed to prolong the distribution during your beneficiary's lifetime, should the beneficiary want that (some will want the money right away).
Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets. You may change the beneficiary later without affecting the amount you withdraw (except for a change to or from a spouse more than 10 years younger).
The rules as to how fast your beneficiaries or heirs must withdraw funds from your account and pay the income tax-differ, depending on your beneficiary choice.
Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has options that no other beneficiary has.
Someone Other Than Your Spouse. A child or other non-spouse beneficiary of an IRA can choose to start withdrawals by the end of the year after your death and spread distributions over his or her own life expectancy. This method extends the payout period and the tax deferral. The life expectancy for a 55-year-old, for example, is 29.6 years.
A non-spouse beneficiary of funds in a retirement plan can elect after 2006 to have the funds rolled to an IRA, and then spread withdrawals as described above.
If you name your children as a group as beneficiaries, minimum payouts are based on the life expectancy of the eldest child. On the other hand, if you create a separate share or account for each child, the child uses his or her own life expectancy.
No beneficiary. If you die before April 1 after the year you reach age 70 ½ having named no beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity), all funds must be distributed -and income taxes paid within five to six years of your death. Heirs don't get the option of using their own life expectancy.
If you die on or after that April 1 date without having named a beneficiary or having named your estate as the beneficiary, the money must come out by the end of the period remaining under the IRS table. For example, at age 80 the table period is 18.7. On a death at age 80, the estate or heirs would have 18.7 years to complete withdrawal.
Death before distributions begin. If you should die before the time (age 70 ½) required distributions are to begin, minimum distributions to your beneficiary can be spread over his or her life expectancy.
Estate tax. There may be an estate tax on retirement funds left to someone other than your spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.
The above discussion covered the general rules as to the withdrawal of retirement plan distributions both before and after you die. Now let's look at some specific tax planning techniques, particularly as regards the estate tax, for minimizing the tax bite when the funds accumulated in your retirement accounts (including pension and profit-sharing plans, 401(k) plans, IRAs and rollover IRAs) are passed on to your heirs.
How Your Heirs Are Taxed
The general rule is that, while there may be an estate tax bite at your death, inherited assets are received income-tax-free by your heirs. Unfortunately, this general rule doesn't apply to money in a retirement plan. Whoever gets the money will incur income tax on it, unless it's left to charity (more on giving retirement assets to charity below).
The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates, except for after-tax investments, which come out tax-free. There are, however, the following key exceptions or qualifications:
Some Tax Planning Opportunities
The federal estate tax isn't a major problem for most Americans. Less than two percent of those who die in any year leave an estate that's hit by the estate tax; but the larger a taxpayer's retirement account, the more likely it will be cut down by the federal estate tax on top of the federal income tax described above.
Unlike the income tax, which is collected only as amounts are distributed--and thus is deferred on annuities and the like--the estate tax is collected up front, at the owner's death, on the present value of the annuity.
One common planning technique-making lifetime gifts to reduce your taxable estate is impractical for retirement accounts. Even where you might be able to give part of your retirement account away (as with an IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter survives for your donee. But here are more practical techniques: