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TABLE OF CONTENTS

Withdrawal While You're Alive
Withdrawal After You Die
Tax Planning
INFOSOURCES

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 70-1/2. 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 you do not need to begin these mandatory withdrawals if you are still employed when you reach the mandatory withdrawal age (unless you’re an owner of the business, in which case you are subject to the mandatory withdrawal rules).

The law also has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail your heirs’ ability to prolong a tax shelter that started out to aid your retirement. The speed with which the money must be withdrawn depends not only on who inherits it, but also on how old you are when you die.

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.

WITHDRAWAL WHILE YOU'RE ALIVE

Before You Reach Age 70-1/2

Until the year you reach 70-1/2, you need not take your money out of your retirement account-—though your employer’s plan might require you to do so. In fact, there will usually be a 10% early-withdrawal penalty if you make withdrawals from an IRA before age 59-1/2. Between the ages of 59-1/2 and 70-1/2 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 70-1/2

Once you hit 70-1/2, withdrawals must begin. They must take place at least fast enough to deplete the account by the end of your life expectancy or the joint life expectancy of you and your beneficiary.

According to IRS tables, a 70-year-old has a life expectancy of 16 years. Therefore, one way to satisfy the tax rules would be to take one-sixteenth of the balance in your IRA the first year, one-fifteenth of what's left the next year, then one-fourteenth, and so on.

Still assuming you are 70 years old, if your 65-year-old spouse is your designated beneficiary, the joint life expectancy is 23.1 years. This means that you can lengthen the period of your withdrawals--and the benefit of the retirement plan tax deferral--by seven more years.

Your beneficiary can be anyone, but you cannot obtain an extremely long payout period by, say, naming an infant grandchild as beneficiary. Unless the beneficiary is your spouse, the beneficiary is assumed to be no more than ten years younger than you for the purpose of computing joint life expectancy.  

WITHDRAWAL AFTER YOU DIE

The rules as to how fast your heirs must withdraw funds from your account—and pay the income tax—differ, depending on whether you die before or after age 70-1/2.

If You Die Before Age 70-1/2

If you die before age 70-1/2, here's how the law applies to various beneficiaries:

Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has several options that no other beneficiary has.

• Rollover. A spouse-beneficiary can roll over part or all of the money to his or her own IRA. A rollover provides the optimal deferral of tax, since your spouse doesn't have to start withdrawing funds until he or she turns 70-1/2.

• Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the money in the account. There's no 10% early-withdrawal penalty if the spouse takes funds out of your account, but that penalty would apply if the spouse rolled over the money into his or her own IRA and tapped it before reaching 59-1/2.

Someone Other Than Your Spouse. A child or other non-spouse beneficiary 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 28.6 years.

If you name your children as a group as beneficiaries, minimum payouts are based on the life expectancy of the eldest child.

There may be an estate tax on retirement funds left to someone other than your spouse and they will pay an income tax as funds are withdrawn. Where an estate tax is imposed, the beneficiary is entitled to a partial income tax deduction for the estate tax paid. If you have 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 to your heirs—and income taxes paid—within five years of your death. Heirs don't get the option of using their own life expectancy.

If You Die After Age 70-1/2

If you die after age 70-1/2 without having named a beneficiary or having named your estate as the beneficiary, your heirs have to take the money at least as fast as you would have been required to withdraw the funds.  (They cannot withdraw funds based on their own life expectancy as they could have if you die before age 70-1/2.)

MORE: At  age 70-1/2, you must calculate your life expectancy see Calculating Life Expectancy.

If you have named a beneficiary, doing so after age 70-1/2 cannot slow down the payout schedule (although you can add or change a beneficiary at any time).

TAX PLANNING

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).

Example: If you gave your wife a $500,000 stock-and-bond portfolio, she will not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will be subject to income tax on it, more or less as you would be if you had received the distributions yourself. (Moreover, there may be a further estate tax as well.)

The basic 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:

• On a lump sum distribution, heirs can claim forward averaging (generally only if death occurred before 2000).
• Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments, the interest element is taxable.
• The value of  a stock bonus is taxable when received as ordinary income, less unrealized appreciation and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
• Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir can roll over from your account.
• There’s no early withdrawal penalty on what your heir withdraws after your death, even if the heir is under age 59 ½. But if your spouse is your heir and rolls over your retirement account  to his or her IRA, a withdrawal from the IRA while under 59 ½ is subject to the penalty unless one of the exceptions applies.

Some Tax Planning Opportunities

The federal estate tax isn’t a major problem for most Americans, Only about 1 in every 100 who die in any year leave an estate that’s hit by 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. With estate taxes ranging (effectively) from 37%-55% and income tax rates from 15%-39.6%, the total tax burden can be severe indeed.

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:

• Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the longest period possible.
• If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and income taxes on this amount while achieving charitable goals.
• A charitable remainder trust is a sophisticated way to benefit family, as well as charity, at a reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from the retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is allowed for the present value of what will go to the charity.
• Consider buying life insurance to pay estate tax that can’t be avoided (perhaps because you want a large retirement account to go to someone other than a spouse or charity). The insurance proceeds will be exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to income tax). With proper planning, the withdrawn funds can escape estate tax as well.

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Related FGs

• SELLING YOUR HOME: How To Minimize The Tax On The Gain

• HIGHER EDUCATION COSTS: How To Get The Maximum Deduction

• ANNUITIES: How They Work And When You Should Use Them

• ROTH IRAs: How they Work And How To Use Them

• RETIREMENT PLAN DISTRIBUTIONS: HOW To Take Them

• MUTUAL FUND TAXATION: How To Cut The Tax Bite

• RECORDKEEPING AND CASH FLOW: Effective Techniques

External Sites

Because tax planning is so specific to a taxpayer's needs and situation, External Sites—which are, of  necessity, general in their scope and application—-can be misleading.  Accordingly, professional guidance should be sought for your particular tax planning needs.

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CALCULATING LIFE EXPECTANCY

At age 70-1/2 you must choose between two methods for calculating life expectancy.

• Fixed-Term Method. Under this plan, payouts are made over a fixed number of years based on your life expectancy or the joint life expectancy with your  beneficiary when you're 70-1/2. If you choose this method and base payouts on your life expectancy alone, then your beneficiary receives distributions over the rest of your life expectancy. But if you use a joint life expectancy to calculate benefits, then your spouse or other beneficiary continues to get payouts over the longer term of the joint life expectancy.
• Recalculation Method. This method refigures your required minimum payout each year using your (or you and your beneficiary's) actual life expectancy. As you get older, your life expectancy increases. This method recognizes that reality and allows smaller minimum payouts than a fixed-term calculation. Some people choose this method in order to avoid outliving their money.

CAUTION: There might be a potential tax glitch here. Unlike your projected life expectancy, your actual life expectancy ends when you die. Thus, if you base distributions on recalculating your life expectancy and don't have a designated beneficiary, the entire balance must be paid out by December 31 of the year after the year you die. That guarantees there will be a quick tax bill for your heirs.

If you recalculate both your and your spouse-beneficiary's life expectancies each year, then when one of you dies, that person's life expectancy drops to zero, and future calculations are based only on the survivor's life expectancy. This accelerates withdrawals. But the real problem comes at the survivor's death, at which time the entire balance must be paid out, and taxed, by the end of the following year.

TIP: if your spouse-beneficiary survives you, he or she can always choose to take a lump sum and roll it over into an IRA, as discussed earlier. This is true whether the recalculation or fixed term method is used. A spousal rollover is a great way to clean up mistakes you made at age 70-1/2.

TIP: When choosing whether to slow down payouts during your lifetime by using the recalculation method, consider how important the option of delaying payouts will be to your heirs. In many cases they may be more interested in getting the money right away than in potential tax savings.

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