Published Saturday, January 10, 2015 at: 7:00 AM EST
The individual retirement account (IRA) is a time-tested way to save for retirement. Typically, you make contributions to an IRA during your working career, or you roll over funds to an IRA from a 401(k) or another employer plan, or both. You might end up with a sizable stash from which you'll be able to withdraw during retirement.
But you may not have to tap that part of your nest egg much if you can rely upon retirement income from other sources, though you will have to take required minimum distributions (RMDs). If it looks as if much of the account will survive you, you might consider the potential benefits of a "stretch IRA." That can help an IRA be there for your chosen beneficiaries long after you're gone.
Under the rules for IRAs, you can take as much as you want out of your account whenever you want, although there's normally a 10% tax penalty on distributions you take before you reach the age of 59½. At the same time, though, you can leave money in the IRA indefinitely, except for taking the RMDs that must begin when you hit age 70½. Those are taxed as ordinary income, which means the tax rate on that money may be as high as 39.6%. And there can be other tax consequences, too.
The idea behind the RMD rules is to force you to use, and pay tax on, the funds that have been accumulating in the account without being touched by taxes. The amount of your annual RMD normally will be based on your account balance on December 31 of the prior year, with that amount divided by your life expectancy according to an IRS table. For example, a 75-year-old with $500,000 in IRA assets would use a factor of 22.9 from the universal life expectancy table to get an RMD of $21,834 for the current tax year.
This system is designed to exhaust the account if you live long enough. But there's an alternative that could reduce the size of the RMDs. If you designate your spouse as the IRA's sole beneficiary, and if your spouse is more than 10 years younger than you, RMDs can be based on your joint life expectancy. Assuming our 75-year old owner with $500,00 in IRA assets has a 60-year-old spouse, their joint life expectancy would be 26.5, resulting in an RMD for the year of $18,868.
The basic concept behind the stretch IRA is to postpone withdrawals as long as possible and to minimize RMDs both before and after your death. The following steps could help you get there:
Make sure you have properly established beneficiaries, both primary and secondary, for all of your IRAs. Double-check your paperwork.
Limit your RMDs to the amount you're required to withdraw. Withdrawing the bare minimum allows you to preserve a larger nest egg.
When you die, your beneficiaries who inherit what's left of your account can arrange payouts based on their life expectancies. If they're younger than you were, the RMDs will be smaller.
If you have multiple beneficiaries, each one should establish a separate account for his or her inherited IRA assets. RMDs have to begin in the year following the year of death. Without separate accounts, RMDs will be based on the life expectancy of the oldest beneficiary. Dividing your account will reduce the RMDs for younger beneficiaries.
Name successor beneficiaries. This ensures that RMDs will be withdrawn over your beneficiaries' entire life expectancies, even if they don't live that long. Otherwise, a beneficiary's estate might have to pay out the entire amount.
Timing can be crucial in establishing a stretch IRA. To qualify for the benefits, your beneficiaries must establish accounts in your name by December 31 of the year after the year of your death. That leaves some time for making decisions about inherited IRA funds, but it's important not to dilly-dally.
It's also essential for your heirs to follow the rules on RMDs. The tax penalty for failing to take one, whether you're the original IRA owner or a beneficiary of an inherited account, is equal to 50% of the required amount (less any amount that actually was withdrawn). Returning to our example of a 75-year-old IRA owner with $500,000 of assets, failing to take the RMD this year could result in a penalty as high as $10,917 (half of $21,834). And that's on top of regular income tax.
Note that lifetime RMDs aren't mandatory for Roth IRA owners. And while beneficiaries who inherit a Roth must take RMDs based on their life expectancies, those distributions generally aren't taxable.
This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.