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Your IRA's Unsolicited Silent Partner

January 13, 2014 | About:

Don’t let required minimum distributions blindside you.

Most of us think often about the best ways to build up our retirement accounts. 401k and traditional IRA accounts are generally funded with pre-tax money. If you are lucky or skillful enough to grow those balances substantially, you may run into unexpected problems.

Tax deductions on money contributed seemed like no-brainers initially. You deferred federal income tax on those amounts, plus anything they earned later, until your money would be withdrawn.  

Like all "buy now, pay later" deals, the benefits accrued immediately while the pain was pushed down the road. IRS rules require you to start withdrawing money from most retirement plans (excepting Roth IRAs)  no later than the year you turn 70 ½ even if you are not yet retired.

Why do they force you to do that? The government wants your money and it is tired of waiting for it.

If you started your IRAs early in life and achieved reasonable success, you and your spouse might find each of you holding seven-figure IRA account balances.

Once Required Minimum Distributions (RMDs) kick in, the taxman dictates that, in each subsequent year, you must withdraw an amount based on your projected life expectancy.

Washington charges a staggering 50% penalty in additional to any tax owed if you mess up on RMDs. Messing up is defined as skipping a mandatory withdrawal or simply taking less than what the IRS determined you should.

If a bank or commercial business charged a 50% penalty for late, or less than full payments, there would be a public outcry. That is "business as usual" for the IRS, though.

The IRS refuses to give clear and easy instructions on how much you need to take out. They do provide tables that require a bit of input and intelligence to figure RMDs accurately.

My example uses the simplest form – for Single Life Expectancy based on age in the year of the withdrawal. If you manage to stay alive to age 100, the friendly actuaries at the IRS generously figure you could make it to almost 103.

To determine your IRA’s RMD you need to know the Dec. 31 combined value of all your IRA accounts, if you own more than one, from the previous calendar year. Then you must convert your projected life expectancy (from the table shown above) to a percentage.

If your 70.5-year-old spouse had similar success with their IRA, they also have to take an annual RMD. Your family's joint income would include an extra $117,648 in 2014.  That extra "income," which represents nothing more than a location shift, from your retirement accounts to your non-retirement accounts, becomes taxable at your highest marginal ordinary income tax rate. 

It will also automatically trigger taxation on 85% of any social security benefits received that year. 

If a couple were each 80 years old, with million-dollar IRAs, their combined RMD would be 1/10.2 = 9.80% of $2,000,000 or $196,000 just for that year. Add in social security benefits, dividends and interest, any pensions you might be collecting and you could become unexpectedly subject to tax rates of 43.4% — the revived top bracket of 39.6% plus the 3.8% Obamacare surcharge,  just at the federal level. Some state and local governments add their own income tax levies to retirement distributions.

Things get very complex if you die while still holding money in traditional IRA accounts. If your spouse is your sole beneficiary, it’s not too bad. Heirs should be sure to get good advice before deciding how to proceed.

You can see answers to frequently asked questions regarding RMDs at IRS.gov but remember — the IRS is not going to provide any help in minimizing the tax bite.

http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Required-Minimum-Distributions

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.TalkMarkets.com

Visit Dr. Paul Price's Website


Rating: 4.3/5 (13 votes)

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Comments

Matt Blecker
Matt Blecker - 7 months ago

The wrong table is used above.  RMDs are calculated using the uniform distribution table, which is the joint life expectancy of an IRA owner and a spouse who is assumed to be 10 years younger.  Those with a spouse more than 10 years younger may use a more generous calculation.  The single life expectancy table is only used by beneficiaries of IRAs, mainly non-spouses, who may stretch the IRA over their life expectancy.

AlbertaSunwapta
AlbertaSunwapta - 7 months ago

There may be more risks if there is comparability to the Canadian situation.  In Canada we have RRSPs (Registered Retirement Savings Plans) which must then be converted to RRIFs (Registered Retirement Income Funds) in old age with mandated withdrawals (I'm years and years from needing to know the details).  I've always maximized my contributions to my RRSP.

That said, I've done so knowing the following risks:  Capital losses are not tax deductible but equities have historically been the best way to accummulate wealth so I've held substantial equity postions in my registered retirement fund.  So one has to be extremely fearful of having a large allocation to equities at or near retirement should the market hit a Great Crash/Great Depression collapse, or for that matter, a Japanese style 20 year long pothole while you face forced or mandated portfolio liquidation. 

Additionally, marginal tax rates historically bounced around to a dramatic extent. So beside the obvious risk that too much success in investing may mean a very high reitrement income at a high MTR, another risk is that simple massive federal debt may lead the government to raise the MTRs thus penalizing your for saving and deferring consumption.  One should look at the history of MTRs going back to the 1910s, 20s, 30s and the 1970s. It's eye opening.

LwC
LwC - 7 months ago

In the USA there's actually a more insidious result to investing in equities through tax deferred savings accounts, one that I have never seen the purveyors of such accounts disclose in marketing materials: the potential conversion of qualified long term holding tax treatment into ordinary tax treatment.

Under current tax rules, any gain on an equity investment held for more than a year qualifies for the lower "long term capital gains" tax rate. However, if that equity is held in a tax deferred account, when the cash from the sale of that equity, including any gain, is withdrawn from the tax deferred account, it is taxed at the ordinary tax rate, which is currently twice the long term capital gains rate.

The general assumption is that one presumably makes the tax deferred contribution to the account while in a relatively high tax bracket, and then in retirement withdraws from the account at a lower tax rate because in retirement one will have a lower taxable income. That may very well be true for some people, but IMO ordinary tax rates in retirement will usually not be as low as the current tax rate on long term capital gains for most investors. One's taxable income would have to be pretty low to be taxed at an ordinary tax rate equal to or less than the current long term capital gain rate. It's a fact that most beneficiaries of tax deferred accounts are high income earners and will continue to be high income earners even in retirement; therefore they are unlikely to benefit from the effect of that assumption.

Sure tax treatment rules may change in the future, and is even likely to change, but the fact is that the special tax treatment for qualified long term capital gains has been around in some form or other for a long time and is unlikely to ever be eliminated.

Disclaimer: consult your tax advisor.

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