Funding Retirement - Part I: IRAs

- By Scot Kamins for SeasonedSpender.com
©2008 Scot Kamins & Ron Holl

We're living in a far different world from the ones our parents lived in. For many people, it used to be that you'd get a job at a company, work for it until you were about 65, and then retire to live on the company pension supplemented by Social Security income.

Starting with the Boomer generation, lifetime employment with the same company began to disappear. And fewer and fewer companies provided complete pension plans. Additionally, inflation has eroded savings: Even the combination of old pensions plus social security income has proven inadequate.

The advent of various forms of tax-advantaged programs including partial pension plans such as 401(K)s in which the company pays part and the employee pays part, Keoghs for self-employed people, and various forms of IRAs have taken up the slack. But money is still tight and inflation is on the rise. So as more of us enter retirement, it's more important than ever that folks get the most bang for their retirement bucks.

A big part of that means taking money out of our tax-protected positions for daily use in a way that is most advantageous from a tax point of view: In other words, how do we get as much out of our retirement plans as possible while paying the least amount of taxes?

General Disclaimer: I'm not an accountant, tax attorney, or IRS employee, nor am I specially trained in retirement finance. I am, however, a pretty good researcher. I've gathered together the top level of information you need to know before you start taking money out of a retirement plan. Treat the information in this article with that in mind. And I recommend strongly that you do what I did — speak with a CPA before you begin to withdraw retirement funds.

IRA = Any Retirement Plan: For simplicity, in this article the term IRA refers to any and all non-Roth retirement plans (SEP-IRAs, traditional IRAs, 401(K)s, Keoghs) in which you participate. Social Security income is treated next month in Part II.

IRA and Keoghs and 401(K)s — Oh My!

There are all kinds of tax-advantaged plans you can use to put money aside for retirement. While technical details about setting up and paying into these retirement schemes differ, they're pretty much the same when it comes to the general rules of getting penalty-free money out of them:

• None of your IRA investments are in prohibited categories such as collectibles or property purchased for personal use (as opposed to property used as rentals)
• You need to be in the year in which you reach 59 1/2 before you can start withdrawing money. Except for certain exceptions if you withdraw money early you're subject to a penalty of 10% of the money you take out.
• You can withdraw as much as you want at any time after the minimum age.
• You can withdraw as little as you want (or nothing at all) until the year in which you reach 70 1/2.
• You must start withdrawing money by April 1 of the year following the year you reach 70 1/2. The amount you must withdraw that year and every year thereafter is the dollar value of the IRA/Keogh/401-K divided by your future life expectancy. (More on this later.)
• Distributions are taxed at the same rate as earned income (as opposed to capital gains).
• Other income (Social Security receipts, salaries, commissions, interest, and so on) has no impact on the amount you can or must withdraw.

Getting Money Out Early

Under certain conditions you can withdraw money from these private retirement plans before you reach the standard minimum age. Here are the most common ones:

• You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
• The distributions are not more than the cost of your medical insurance.
• You're disabled.
• You inherited the money from someone else's retirement plan.
• You're receiving distributions in the form of an annuity.
• The distributions are not more than your qualified higher education expenses.
• You use the distributions (up to $10,000) to buy, build, or rebuild a first home.
• The IRS took money out of the plan to pay a fine or for some other reason.
• You stop working for a company in which you have a Keogh account at age 55 or older.

And It Ain't That Simple: Every one of these exceptions have qualifications, limits, sub-exceptions, and other stuff that make them far more complex than they seem at first blush. As Tom Waits said, "The large print giveth, and the small print taketh away."For the excruciating details, click here.

Required Minimum Distribution

By April 1 of the year following the year you reach 70 1/2, you must start withdrawing money annually from your IRA. The IRS gives this example:

• You reach age 70 ½ on August 20, 2007. For 2007, you must receive the required minimum distribution from your IRA by April 1, 2008. You must receive the required minimum distribution for 2008 by December 31, 2008.

The minimum you must withdraw annually, called the Required Minimum Distribution or RMD, is a fraction of the total value of your IRAs (exclusive of Roths), your life expectancy, and your marital status including, if you're married, the difference in the ages between you and your spouse. The IRA value is its value at the end of the year preceding the year for which the required minimum distribution is being figured. The life expectancy is based on actuarial tables; click here to see the tables that the IRS uses. (When you get there, search for/scroll down to "Appendix C. Life Expectancy Tables".)

The basic formula is RMD = IRA Value/Life Expectancy.

So for example, you're 72 and single. Looking at the IRA's table, you see that your life expectancy is 15.5. And on December 31st of last year (2007), the total value of your IRA was $500,000. Applying the formula: RMD = $500,000 / 15.5, which is $32,258.00. So you must withdraw $32,258 from your IRA during the current year (2008).

Special Rules for Annuities: If your IRA is an individual retirement annuity, special rules apply to figuring the required minimum distribution. Ask your accountant. (See? I told you it wasn't that simple.)

A Note about Roths: Unlike other IRAs, you can make contributions to your Roth IRA after age 70 ½. And there are no required minimum distributions from Roth IRAs.

Tax/Income Considerations: IRA withdrawals or Long Term Capital Gains?

The benefit of IRAs is that funds can build tax-deferred — you don't pay taxes until you withdraw funds, and then you pay taxes only on the amount withdrawn (assuming you don't withdraw funds too early and if applicable you're taking any required minimum distribution). But as soon as you take funds out, the withdrawn funds are subject to regular income tax for the year in which you make the withdrawal. Don't be confused — these funds are considered regular income, not long-term capital gains. Depending on your tax bracket, regular income is generally taxed at a higher rate than long-term capital gains.

This is especially true for tax years 2008 through 2010: Single people whose total taxable income including long-term capital gains would be $32,550 or less and couples with total taxable incomes of $65,100 or less including long-term capital gains — the top of the 15% tax bracket — are exempt from capital gains. So for example, you're a couple whose taxable ordinary income after all deductions is $45,000: you don't have to pay taxes on up to $20,100 in capital gains. (Gains over the total $65,100 would be taxed at 15%, the current tax rate on long term capital gains.)

This all means that, if you're lucky enough to have both regular investments as well as IRAs, you need to consider what to use as your income source. It may be wiser to withdraw money from investments providing the more favorable long-term capital gains rate. Check with your tax consultant to be sure.

Roth Withdrawals are Tax-Free: Assuming you're over 59 1/2 and haven't violated any Roth rules for over-contributions and the like, Roth withdrawals are tax-free. Further, you can take as much or as little out of your Roth whenever you like. (There are some distribution requirements that apply to Roths that you leave to your heirs. Click here to see the rules.) So if you have a Roth IRA and taxes are a consideration, you might want to add the possibility of withdrawing from your Roth as an income source.

Source Links Used in This Article

IRA Page at Wikipedia - Basic article describing a number of different IRA types and the rules governing their set-up and use.

Roths IRAs - AARP's take on this tax-free retirement vehicle. "The most attractive parts of a Roth IRA are that your money grows tax-free, and your money is withdrawn without paying federal taxes."

IRS IRA Table of Contents - The Internal Revenue Service's kick-off page for all things IRA. Leads to all manner of documents covering specific IRA topics.

~ Next month - Part II: Social Security Retirement Benefits ~