Retirement
Income: IRAs
In general
If
you're like most people, individual retirement accounts and individual
retirement annuities (IRAs) comprise a significant portion of your retirement
nest egg. It's important to understand when you can (and must) begin taking
distributions from your IRAs, the tax consequences, and how to incorporate your
withdrawals into your retirement income plan.
Caution: Although most states follow the federal income tax treatment
of traditional or Roth IRAs, some do not. You should check with your tax
advisor regarding the tax treatment of IRAs in your particular state.
Distributions from traditional IRAs:
Prior to age 59½
The
purpose of IRAs is to provide income to help fund your retirement years, and the federal
government wants to make sure you use the money for that purpose. If you
receive a distribution from your traditional IRA before you reach the age of
59½, the IRS considers this a premature distribution. Like all distributions
from traditional IRAs, premature distributions are generally taxable. You will
pay federal (and possibly state) income tax on the portion of the distribution
that represents tax-deductible contributions, any pre-tax funds that were
rolled over into the IRA from an employer-sponsored retirement plan, and
investment earnings. In addition to regular income tax, distributions taken
prior to age 59½ may be subject to a 10 percent federal premature distribution
penalty tax (and possibly a state penalty) on the taxable portion of the
distribution.
The
penalty tax is meant to encourage you to leave your money in the IRA until age
59½ or later. This reduces the risk that you will deplete your funds
prematurely and run out of money at some point in retirement. The assumption is
that by the time you reach age 59½, you are either already retired or near
retirement, and can safely begin using your retirement money.
Income
taxes on IRA and retirement plan distributions can really add up. When a
distribution is also subject to the 10 percent federal penalty, the portion of
the distribution that goes into your pocket obviously dwindles even further. If
you are close to age 59½ and wish to take a distribution from your traditional
IRA, check the calendar carefully to avoid a potentially costly mistake.
Exceptions to the premature
distribution tax, including SEPPs
Unless
you qualify for an exception, taxable amounts you withdraw from a traditional
IRA before age 59½ are subject to a federal 10 percent premature distribution
tax (and possibly a state penalty tax, too). This premature distribution tax is
assessed in addition to any federal (and possibly state) income tax due.
Fortunately, Section 72(t) of the Internal Revenue Code lists several
exceptions. For example, the penalty doesn't apply if you have a qualifying
disability, or if you use the proceeds to pay certain unreimbursed medical
expenses.
However,
one of the most important exceptions, from a retirement income perspective,
involves taking a series of "substantially equal periodic payments"
(SEPPS) from your IRA. This
exception is important because it's available to anyone, regardless of age, and
the funds can be used for any purpose.
SEPPs
are payments that are calculated to exhaust the funds in your IRA (or
combination of IRAs) over your life (or life expectancy), or over the joint
lives (or joint life expectancy) of you and your beneficiary. To meet the SEPPs
exception, you must use an IRS-approved distribution method, and take at least
one distribution annually. There are three IRS-approved methods for calculating
SEPPs, each of which requires that you select a life expectancy or mortality
table, and two of which require that you select a reasonable interest rate.
Technical Note: The three IRS-approved methods for determining annual
payments that qualify as substantially equal periodic payments are the RMD
method, the fixed amortization method, and the fixed annuitization method. The
rules for calculating your SEPPs can be found in IRS Notice 89-25 and Revenue
Ruling 2002-62.
If
you have more than one IRA, you're not required to aggregate all of them in
order to take advantage of the SEPPs exception. You can consider the account
balance of only one of your IRAs, or you can elect to aggregate the account
balances of two or more of your IRAs. But you can't use only a portion of an
IRA to calculate your SEPPs. Because you're not required to aggregate all of
your IRAs, you can use tax-free rollovers to ensure that the IRA that will be
the source of your periodic payments contains the exact amount necessary to
generate the specific payment amount you want. This makes the SEPPs exception a
very important and flexible retirement income planning tool.
Even
though your payments must be calculated as though they will be paid over your
lifetime (or over your and your beneficiary's lifetimes), you don't actually
have to take distributions for that long. You can change, or stop, your SEPPs
after payments from your IRA have been made for at least five years, or after
you reach age 59½, whichever is later. If you modify or stop the payments
before then, you'll generally be subject to the 10 percent premature
distribution tax on the taxable part of all payments you received before you
reached age 59½ (unless the modification was due to death or disability). In
addition, interest may be imposed.
Tip: The five-year period begins on the date of the first
withdrawal, so no modification can be made before the fifth anniversary of that
withdrawal. This is true even if you turn age 59½ before the fifth anniversary
of that withdrawal.
Example(s): Assume John began taking annual distributions from his
traditional IRA account three years ago, when he was 43 years old. (John has
taken these distributions according to an IRS-approved method.) John does not
take a distribution this year. Because John's payment stream has been
"modified," the 10 percent penalty will now apply retroactively to
all of his previous distributions, and interest may also be imposed. (A state
tax penalty may apply, as well.)
Assume
that John began taking annual distributions from his traditional IRA on October
1, 2011, when he was 57½ years old. He also took the correct annual
distributions in 2012, 2013, and 2014 (when he was age 60). Even though he was
over age 59½ on October 1, 2014, he must take one more required distribution by
October 1, 2015. Otherwise, he'll be subject to the 10 percent penalty on the
taxable portion of the distributions he took when he was under age 59½.
Caution: To ensure that your distributions will qualify for the SEPPs
exception to the premature distribution tax, get professional advice. The
calculation of SEPPs can be complicated, and the tax penalties involved in the
event of an error can be significant.
Should you take distributions from your
traditional IRA before age 59½?
You
are allowed to take distributions from your traditional IRA whenever you like
and in any amount you choose. That does not mean, however, that you should. As
a general rule, it is not advisable to take distributions from a traditional
IRA before age 59½ (or for that matter, at any age prior to your retirement).
First, as illustrated above, the portion of the distribution that goes to the
federal government for taxes can be substantial--not to mention state taxes and
penalties. This is especially true if the entire distribution is taxable, or if
none of the exceptions to the premature distribution tax apply.
In
addition, even if all or some of the distribution will not be taxed or
penalized, taking IRA distributions before age 59½ may still be unwise. By
dipping into your IRA funds at a relatively young age, you run the risk of
depleting those funds sooner than you had anticipated. This could jeopardize
your retirement goals and financial security later in life. Funds removed from
an IRA may also be missing out on several years or more of potential
tax-deferred growth, depending on investment performance.
However,
the decision of whether to tap into your IRA nest egg ultimately depends on
your individual circumstances. Perhaps you have urgent expenses, and
withdrawing from your IRA is the only way you can pay them. It is also possible
that you have accumulated large balances in your IRAs and other retirement
accounts, so that withdrawing from your IRAs now will not pose a risk to your
future financial security. In these cases, taking distributions before age 59½
is not necessarily ill-advised. Whatever your situation, though, you should
consult a tax professional before taking a distribution.
Distributions from Traditional IRAs:
Between Ages 59½ and 70½
Once
you reach the age of 59½, you are allowed (but not required) to take
distributions from your traditional IRA without being subject to the 10 percent
premature distribution tax. You may choose to take distributions sporadically,
as you need the money, or you may request an automatic distribution from your
account according to a prearranged schedule you establish with your IRA
administrator.
Should you withdraw money from your IRA
between ages 59½ and 70½?
It
depends on your circumstances. If you really need the money for income or
unforeseen expenses, you might consider drawing on your IRA. However, if you
have other sources of income and don't need the IRA funds, you may want to
think twice about withdrawing funds. Even though you will be free of the
premature distribution tax once you've reached age 59½, you still may have to
pay income taxes on all or part of any IRA withdrawals (depending on whether or
not the contributions you made were tax deductible). If the amount of a taxable
distribution is substantial, it may even push you into a higher tax bracket for
that year. This could increase your annual tax liability significantly.
In
addition, if you take a number of large IRA distributions after reaching 59½,
your IRA could be depleted (or at least reduced in size) more quickly than you
had planned. This could mean a smaller nest egg for your later retirement years
when you may need income the most, and a much smaller balance available to
leave to your beneficiaries when you die. And, of course, the longer you leave
funds in an IRA, the greater the opportunity for compounded, tax-deferred growth of earnings.
The point is that it's generally not wise or appropriate to take distributions
from an IRA between ages 59½ and 70½.
Distributions from traditional IRAs:
After Age 70½
Ideally,
you would like to have complete control over the timing of distributions from
your traditional IRAs. Then you could leave your funds in your IRAs for as long
as you wished, and withdraw the funds only if you really needed them. This
would enable you to maximize the funds' tax-deferred growth in the IRA, and
minimize your annual income tax liability. Unfortunately, it doesn't work this
way. You must take what are known as required minimum distributions from your
traditional IRAs.
What are required minimum
distributions?
Required
minimum distributions (RMDs), sometimes referred to as minimum required
distributions (MRDs), are withdrawals that the federal government requires you
to take annually from your traditional IRAs after you reach age 70½. You can
always withdraw more than the required minimum in any year if you wish, but if
you withdraw less than required, you will be subject to a federal penalty tax.
RMDs are calculated to dispose of your entire interest in the IRA over a
specified period of time. The purpose of this federal rule is to ensure that
people use their IRAs to fund their retirement, and not simply as a vehicle of
wealth transfer and accumulation.
When must RMDs be taken?
Your
first RMD represents your
distribution for the year in which you reach age 70½. However, you have some
flexibility in terms of when you actually have to take this first-year
distribution. You can take it during the year you reach age 70½, or you can
delay it until April 1 of the following year. Since your first distribution
generally must be taken no later than April 1 following the year you reach age
70½, this date is known as your required beginning date (RBD). Required
distributions for subsequent years must be taken no later than December 31 of
each calendar year until you die or your balance is reduced to zero. This means
that if you opt to delay your first distribution until the following year, you
will be required to take two distributions during that year--your first-year
required distribution and your second-year required distribution.
Example(s): You own a traditional IRA. Your 70th birthday is December 2
of year one, so you will reach age 70½ in year two. You can take your first RMD
during year two, or you can delay it until April 1 of year three. If you choose
to delay your first distribution until year three, you will have to take two
required distributions during year three--one for year two and one for year
three. That is because your required distribution for year three cannot be
delayed until the following year.
Should you delay your first RMD?
Your
first decision is when to take your first RMD. Remember, you have the option of
delaying your first distribution until April 1 following the calendar year in
which you reach age 70½. You might delay taking your first distribution if you
expect to be in a lower income tax bracket in the following year, perhaps
because you'll no longer be working or will have less income from other
sources. However, if you wait until the following year to take your first
distribution, your second distribution must be made on or by December 31 of
that same year.
Receiving
your first and second RMDs in the same year may not be in your best interest.
Since this "double" distribution will increase your taxable income
for the year, it may cause you to pay more in federal and state income taxes.
It could even push you into a higher federal income tax bracket for the year.
In addition, the increased income may cause you to lose the benefit of certain
tax exemptions and deductions that might otherwise be available to you. So the
decision of whether or not to delay your first required distribution can be
crucial, and should be based on your personal tax situation.
Example(s): You are unmarried and reached age 70½ in 2014. You had
taxable income of $25,000 in 2014 and expect to have $25,000 in taxable income
in 2015. You have money in a traditional IRA and determined that your RMD from
the IRA for 2014 was $50,000, and that your RMD for 2015 is $50,000 as well.
You took your first RMD in 2014. The $50,000 was included in your income for
2014, which increased your taxable income to $75,000. At a marginal tax rate of
25 percent, federal income tax was approximately $14,606 for 2014 (assuming no
other variables). In 2015, you take your second RMD. The $50,000 will be
included in your income for 2015, increasing your taxable income to $75,000 and
resulting in federal income tax of approximately $14,843. Total federal income
tax for 2014 and 2015 will be $29,449.
Now
suppose you did not take your first RMD in 2014 but waited until 2015. In 2014,
your taxable income was $25,000. At a marginal tax rate of 15 percent, your
federal income tax was $3,295 for 2014. In 2015, you take both your first RMD
($50,000) and your second RMD ($50,000). These two $50,000 distributions will
increase your taxable income in 2015 to $125,000, taxable at a marginal rate of
28 percent, resulting in federal income tax of approximately $28,071. Total
federal income tax for 2014 and 2015 will be $31,336--almost $1,887 more than
if you had taken your first RMD in 2014.
How are RMDs calculated?
RMDs
are calculated by dividing your traditional
IRA account balance each year by the applicable distribution period. Your account
balance is calculated as of December 31 of the year preceding the calendar year
for which the distribution is required to be made. The applicable distribution
period is generally the life expectancy factor for your age set out in the
Uniform Lifetime Table published by the IRS. (If your beneficiary is your
spouse, and he or she is more than 10 years younger than you, the applicable
distribution period is determined using a joint and last survivor table
published by the IRS.)
Caution: When calculating the RMD amount for your second distribution
year, you base the calculation on your account balance in the IRA as of
December 31 of the first distribution year (the year you reached age 70½),
regardless of whether or not you waited until April 1 of the following year to
take your first required distribution.
Example(s): You have a traditional IRA. Your 70th birthday is November 1
of year one, and you therefore reach age 70½ in year two. Because you turn 70½
in year two, you must take an RMD for year two from your IRA. This distribution
(your first RMD) must be taken no later than April 1 of year three. In
calculating this RMD, you must use the total value of your IRA as of December
31 of year one.
If
you have more than one traditional IRA, a required distribution is calculated
separately for each IRA. These amounts are then added together to determine
your RMD for the year. You can withdraw your RMD from any one or more of your
IRAs. (Your traditional IRA trustee or custodian must tell you how much you're required
to take out each year, or offer to calculate it for you.)
Caution: Special rules apply if you have annuitized one or more of
your IRAs.
What if you fail to take RMDs as
required?
If
you fail to take at least your RMD amount for any year (or if you take it too
late), you will be subject to a federal penalty tax. The penalty tax is a 50
percent excise tax on the amount by which the RMD exceeds distributions
actually made to you during the taxable year. You report and pay the 50 percent
tax on your federal income tax return for the calendar year in which the
distribution shortfall occurs.
Example(s): You own a single traditional IRA and compute your RMD for
year one to be $7,000. You take only $2,000 as a year-one distribution from the
IRA by the date required. Since you are required to take at least $7,000 as a
distribution but have taken only $2,000, your RMD exceeds the amount of your
actual distribution by $5,000 ($7,000 - $2,000). You are therefore subject to
an excise tax of $2,500 (50 percent of $5,000), reportable and payable on your
year-one tax return.
Distributions from Roth IRAs
Qualified distributions are completely
tax free
You
are free to make withdrawals at any time from your Roth IRA, but only qualified distributions receive
tax-free treatment. A qualified distribution is not subject to federal income
tax or a 10 percent premature distribution tax. A withdrawal from a Roth IRA
(including both your contributions and investment earnings) is qualified if:
(1) it is made at least five years after you first establish any Roth IRA, and
(2) any one of the following also applies:
·
You
have reached age 59½ by the time of the withdrawal
·
The
withdrawal is made due to a qualifying disability
·
The
withdrawal is made for first-time homebuyer expenses ($10,000 lifetime limit)
·
The
withdrawal is made by your beneficiary or estate after your death
Tip: The five-year holding period begins on January 1 of the tax
year for which you make your first regular contribution to any Roth IRA or, if
earlier, January 1 of the tax year in which you make your first rollover
contribution to any Roth IRA.
Tip: Because the five-year holding period runs from the first day
of the plan year in which you establish any Roth IRA, you should establish one
as soon as you can, even if you can afford only a minimal contribution. The
earlier you satisfy the five-year holding period, the sooner you may be able to
receive tax-free qualified distributions from your Roth IRA.
Nonqualified withdrawals
Even
if you make a withdrawal that fails to meet the requirements for a qualified
distribution, your Roth IRA withdrawal enjoys special tax treatment. When you
withdraw funds from your Roth IRA, distributions are treated as consisting of
your contributions first and investment earnings last. Since amounts that
represent your contributions have already been taxed, they are not taxed again
or penalized (even if you are under age 59½) when you withdraw them. Only the
portion of a nonqualified distribution that represents investment earnings will
be taxed and possibly penalized. All of your Roth IRAs are aggregated when
determining the taxable portion of your nonqualified distribution.
Example(s): In 2013, you establish your first Roth IRA and contribute
$5,000 in after-tax dollars. You make no further contribution to the Roth IRA.
In 2015 your Roth IRA has grown to $5,300. You withdraw the entire $5,300.
Because you withdrew the funds within five tax years, your withdrawal does not
meet the requirements for a qualified distribution. You already paid tax on the
$5,000 you contributed, so that portion of your withdrawal is not taxed or
penalized. However, the $300 that represents investment earnings is subject to
tax and the 10 percent premature distribution tax, unless an exception applies.
Tip: Distributions from Roth
IRAs are generally treated as being made from contributions first and
earnings last (see ordering rules below). In the previous example, if you
withdrew only $5,000 (leaving $300), the withdrawal would be tax free (and
penalty free) since the entire amount would be considered a return of your
contributions.
Technical Note: Technically, a distribution from a Roth IRA that is not a
qualified distribution and is not rolled over to another Roth IRA is included
in your gross income to the extent that the distribution, when added to the
amount of any prior distributions (qualified or nonqualified) from any of your
Roth IRAs, and reduced by the amount of those prior distributions that were
previously included in your gross income, exceeds your contributions to all
your Roth IRAs. For this purpose any amount distributed to you as a corrective
distribution is treated as if it was never contributed.
Your funds can stay in a Roth IRA
longer than in a traditional IRA
The
IRS requires you to take annual RMDs from traditional IRAs beginning at age
70½. These withdrawals are calculated to dispose of all of the money in the
traditional IRA over a given period of time. However, Roth IRAs are not subject
to the RMD rules. In fact, you are not required to take a single distribution
from a Roth IRA during your life (although distributions are generally required
after your death). This can be a significant advantage in terms of your estate
planning.
Special penalty provisions may apply to
withdrawals of Roth IRA funds that were converted from a traditional IRA
If
you rolled over or converted funds from a traditional IRA to a Roth IRA,
special rules apply. If you are under age 59½, any nonqualified withdrawal that
you make from the Roth IRA within five years of the rollover or conversion may
be subject to the 10 percent premature distribution tax (to the extent that the
withdrawal consists of converted funds that were taxed at the time of
conversion). The reason for this special rule is to ensure that taxpayers don't
convert funds from a traditional IRA solely to avoid the early distribution
penalty.
Tip: The five-year holding period begins on January 1 of the tax
year in which you convert the funds from the traditional IRA to the Roth IRA.
When applying this special rule, a separate five-year holding period applies
each time you convert funds from a traditional IRA to a Roth IRA.
Caution: This five-year period may not be the same as the five-year
period used to determine whether your withdrawal is a qualified distribution.
Example(s): In 2012, you opened your first Roth IRA account by converting a
$10,000 traditional IRA to a Roth IRA. You included $10,000 in your taxable
income for 2012. You made no further contributions. In 2015, at age 55, your
Roth IRA is worth $12,000, and you withdraw $10,000. The distribution is not a
qualified distribution because five years have not elapsed from the date you
first established a Roth IRA. And because you are making a nonqualified
withdrawal within five years of your conversion, the entire $10,000 is subject
to a 10 percent premature distribution tax, unless you qualify for an
exception. This "recaptures" the early distribution tax you would
have paid at the time of the conversion.
You
opened a regular Roth IRA account in 2008 with a contribution of $100, and made
no further contributions to the account. In 2012, at age 60, you converted a
$100,000 traditional IRA to a Roth IRA. In 2015, you withdraw $50,000 from this
Roth IRA. Because you are over age 59½ in 2015, and because more than five
years have elapsed from January 1, 2008 (the year you first established any
Roth IRA), your withdrawal is a qualified distribution and is totally free of
federal income taxes. Even though your withdrawal was within five years of the
conversion, no penalty tax applies.
Which assets should you draw from
first?
You
may have assets in accounts that are taxable (e.g., CDs, mutual funds), tax
deferred (e.g., traditional IRAs and 401(k)s), and tax free (e.g., Roth IRAs
and Roth 401(k)s). Given a choice, which type of account should you withdraw
from first? The answer is--it depends.
For
retirees who don't care about leaving an estate to beneficiaries, the answer is
simple in theory: withdraw money from taxable accounts first, then tax-deferred
accounts, and lastly, tax-free accounts. By using your tax-favored accounts
last, and avoiding taxes as long as possible, you'll keep more of your
retirement dollars working for you.
For
retirees who intend to leave assets to beneficiaries, the analysis is more
complicated. You need to coordinate your retirement planning with your estate
plan. For example, if you have appreciated or rapidly-appreciating assets, it
may be more advantageous for you to withdraw from tax-deferred and tax-free
accounts first. This is because these accounts will not receive a step up in
basis at your death.
However,
this may not always be the best strategy. For example, if you intend to leave
your entire estate to your spouse, it may make sense to withdraw from taxable
accounts first. This is because spouses are given preferential tax treatment
with regard to retirement plans. A surviving spouse can roll over retirement
plan funds to his or her own IRA or retirement plan, or, in some cases, may
continue the deceased spouse's plan as his or her own. The funds in the plan
continue to grow tax deferred, and distributions need not begin until the
spouse's own required beginning date.
Another
factor to consider is that IRA assets enjoy special protection from creditors
under federal and most state laws. Federal law provides protection for up to
$1,245,475 (as of April 1, 2013) (and in some cases more) of your aggregate
Roth and traditional IRA assets if you declare bankruptcy. (Amounts rolled over
to the IRA from an employer qualified plan or 403(b) plan, plus any earnings on
the rollover, aren't subject to this dollar cap and are fully protected.) The
laws of your particular state may provide additional bankruptcy protection, and
may provide protection from the claims of your creditors even in cases outside
of bankruptcy. You should check with an attorney to find out how your state
treats IRAs. If asset protection is important to you, this could impact the
order in which you take distributions from your various retirement and taxable
accounts.
The
bottom line is that this decision is a complicated one. A financial professional can help you
determine the best course based on your individual circumstances.
IMPORTANT
DISCLOSURESBroadridge Investor Communication Solutions, Inc. does not provide
investment, tax, or legal advice. The information presented here is not
specific to any individual's personal circumstances.To the extent that this
material concerns tax matters, it is not intended or written to be used, and
cannot be used, by a taxpayer for the purpose of avoiding penalties that may be
imposed by law. Each taxpayer should
seek independent advice from a tax professional based on his or her individual
circumstances.These materials are provided for general information and
educational purposes based upon publicly available information from sources
believed to be reliable—we cannot assure the accuracy or completeness of these
materials. The information in these
materials may change at any time and without notice.
