BY NORMAN G. GRILL
With little fanfare, the traditional IRA has turned 40. It was under the Employee Retirement Income Security Act of 1974 that the original IRA was introduced. Since then, this long-standing retirement funding arrangement has undergone a multitude of major and minor tweaks.
To ensure your IRA serves your purposes, you need to stay up to speed on the distribution rules. Here”™s a review of the current rules in the context of effectively transferring wealth to your heirs.
Starting at age 59½, you can begin taking distributions from a traditional IRA without penalty. With a few exceptions, distributions taken before that age are subject to a 10 percent penalty on top of any income tax that ordinarily would be due on a withdrawal. Required minimum distribution (RMD) rules kick in when an account holder turns 70½, though the first RMD may be delayed until April 1 of the year after turning that age.
Account holders pay tax on distributions at their ordinary federal income tax rates, rather than at the lower long-term capital gains rate they may be eligible for on gains and qualified dividends from investments held outside retirement accounts. But distributions from traditional IRAs that had been funded with nondeductible contributions are partially tax-free.
Consider this example:
You can integrate traditional IRA distributions into your retirement portfolio and then pass the account on to an heir, in a variety of ways. Say two married 65-year-old retirees are living off the dividends and gains from their investments. They want to allow the husband”™s traditional IRA to continue to grow tax-deferred and, ultimately, provide a tax-advantaged inheritance for their 35-year-old daughter.
Because the couple doesn”™t need to tap the funds in the husband”™s plan for retirement living expenses, they could stretch out distributions as long as possible ”” during their lifetimes and beyond ”” and thereby transfer more wealth to their daughter.
The RMD rules would allow them to prolong the tax deferral by taking only small distributions. The first RMD equals only 1/27.4 of the account”™s balance as of Dec. 31 before the year in which the husband turns age 70½. By age 80, there may be nearly as much in the account after earnings and receiving the minimum distributions as there was at 70.
The rules for inherited IRAs vary depending on whether the recipient is the deceased”™s spouse or another beneficiary. Getting back to our example, on the husband”™s death, his traditional IRA can be shifted into a rollover IRA for his wife.
If the wife is under age 70½, she can defer distributions until she reaches that age. After she dies, their daughter, as the beneficiary, will have to decide how to make withdrawals. As the beneficiary of an inherited IRA, she can take everything all at once or at any time during the five-year period after her mother”™s death.
Alternatively, the daughter could begin taking distributions in the year following her mother”™s death and can spread those distributions over her own life expectancy, based on the government”™s single life tables. This typically will result in small required distributions that will allow the account to build value for years to come. A 48-year-old person, for example, would be required to withdraw 1/36 of the total in the account. This fraction slowly increases as the person gets older.
Because it”™s an inherited IRA, the daughter would be disallowed from waiting until she reaches age 70½ to begin taking distributions. Inherited IRAs, however, aren”™t subject to the 10 percent penalty for early distributions. The daughter could, of course, cash out the IRA following her mother”™s death and pay the related tax. In doing so, she”™d lose the long-term tax-deferral benefits.
As you can see, a traditional IRA can be much more than just a retirement funding vehicle. One of these arrangements can also fit into your estate plan. But it”™s imperative to know both the distribution rules and the account”™s potential estate planning impact.
Norm Grill (N.Grill@GRILL1.com) is managing partner of Grill & Partners LLC, (GRILL1.com) certified public accountants and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203-254-3880.
