"Maxing Out" The Benefits of Tax-Deferral in Your IRA

It has been said that eventually "all good things come to an end," and that many things are "not as simple as they first appear." Both of these axioms may be true with respect to the tax-deferred nature of traditional IRAs (Individual Retirement Accounts). Whether you are about to retire, or just doing a little retirement daydreaming, the following IRA information may be important to your wallet.

Current tax rules mandate that minimum distribution requirements begin by April 1st of the year after reaching age 70 1/2 (however, employer-sponsored qualified plan distributions can be postponed until retirement if you continue working past age 70 1/2). The minimum required distribution is the balance of the account as of the previous December 31st divided by an appropriate life expectancy "factor." Failure to take required withdrawals results in a 50 percent tax penalty on the shortfall.

"Wring" It Once?

The first required distribution is actually for the year in which you attain age 70 1/2 - the IRS merely lets you postpone it until April 1st of the following year. If you did postpone the first distribution (i.e., try to "wring" out a little extra tax-deferral), a second distribution would be due by December 31st for the current year, substantially increasing taxable income for that year.

"Wring" It Twice?

The IRS uses life expectancy figures to determine the required minimum distributions (RMDs) IRA holders age 70 1/2 and older must receive. A life expectancy figure approximates the distribution period - the estimated length of time an individual will take withdrawals from his or her IRA. Population trends indicate that people are living longer and, thus, may need income for an extended period of time. In response, the IRS has increased life expectancy figures, and as a result, the mandatory withdrawal amounts have decreased. The reduced requirements may afford people the opportunity to keep their savings tax-sheltered for a longer period of time. It is important to note that an account holder may withdraw more than the minimum, but failure to take the required withdrawals results in a 50% tax penalty on the shortfall.

For most, minimum distributions may now be calculated according to one uniform table based on the joint life expectancy of the taxpayer and a hypothetical beneficiary who is ten years younger, even if no beneficiary is named. If the designated beneficiary is a spouse who is more than ten years younger than the owner, a separate, generally more favorable table (joint life and last survivor expectancy) is used. In the event that a person has more than one IRA, the minimum distributions must be calculated separately for each IRA, because different multiples (i.e., life expectancies) may apply to each IRA. The sum of the separate minimum distributions is the total IRA amount that must be withdrawn for the year. However, this amount can be taken out of any one or more IRA accounts.

To calculate the amount of a required distribution, divide the IRA balance (as of December 31st of the previous year) by the applicable distribution period. For each subsequent year, the required minimum distribution must be recalculated.

The legislative changes also provide greater flexibility for an IRA holder to change beneficiaries. Account holders who have begun receiving payouts may postpone the designation of one or more beneficiaries or change beneficiaries.

Furthermore, primary beneficiaries may refuse or "disclaim" the account, allowing it to pass to a contingent beneficiary, who can then receive distributions based on his or her life expectancy. The lower tax liability on the smaller distribution and the continuation of tax-deffered growth also pass on the the named contingent beneficiary. This change will be welcomed, for example, by couples who want to ensure that IRA assets are available to surviving spouses who, if financially secure, could then disclaim the amounts and pass them on to children or grandchildren.

In trying to "wring" a little extra tax-deferral out of your IRA, be careful not to squeeze too hard. Implementing minimum distribution requirements may come back to put a tax squeeze on you if you haven't thought through the tax consequences.

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