Your Retirement Fund Just Got More Fruitful
Rarely are the words "Internal Revenue Service" and "simplified rules" spoken in the same breath without irony. But surprise! The agency's rules governing the distribution of assets in IRAs and 401(k)s really have been simplified.
Those 70 1/2 and older, who are required to start taking money out of these plans, can now figure the distributions from one straightforward calculation instead of three complex ones. And the IRS lets you assume a longer life expectancy, so you can draw less from your account and leave more behind for heirs.
Still, don't assume this new era of simplicity and flexibility means you can put the whole matter of retirement account distributions on autopilot. "People might get the impression that the IRS took care of everything and you can't make a mistake anymore," says Ed Slott, editor of the newsletter Ed Slott's IRA Advisor (800 663-1340; www.irahelp.com). "The key is still planning."
As before, at age 59 1/2, you can take money penalty-free from these plans. But shortly after turning 70 1/2, you must begin withdrawing or you face a 50% penalty on the difference between what was taken and what should have been taken. The whole idea behind forced distributions is that the government can start collecting taxes on the money that has been accumulated. Roth IRAs are exempt from this because taxes already have been paid on the contributions.
The formula for computing required distributions has not changed: Simply divide your account's yearend balance by your life expectancy. Taxpayers can use the new rules immediately for IRAs. For 401(k)s, the new rules don't take effect until your company amends its plan--and it has until next year to do so.
Under the new rules, the IRS has added years to your life expectancy. Take a 75-year-old man whose beneficiary is his 77-year-old wife. The new rules give the couple a combined life expectancy of 21.8 years--or 6 years longer than before. Why the difference? When the IRS computes life expectancies, it uses the account owner's real age but assumes that the beneficiary is 10 years younger than the account owner. The old system was less generous because it used the beneficiary's real age. If your beneficiary is more than 10 years your junior, you can still use his or her real age. But to get this break, the beneficiary must be your spouse.
SMALLER BITE. The revision is desirable because longer life expectancies reduce the amount that must be taken from your retirement account each year. This gives your assets more time to grow tax-deferred--and helps you leave more to your heirs. "Because the IRS has enabled almost everyone to reduce their minimum distributions, we are going to see larger sums of money accumulate in IRAs and 401(k)s," says Theresa Fry, a retirement planning specialist at A.G. Edwards & Sons in St. Louis. With bequests larger, "estate planning is going to be more important," she adds.
To keep as much of your IRA as possible out of the taxman's hands, it's important to take advantage of the IRS's newfound flexibility in allowing beneficiary changes. The old rules permitted account owners to create a revolving door of beneficiaries. But in most cases, the eventual heir was stuck with a payout schedule dictated by the age of whomever the account owner chose as beneficiary when he or she was 70 1/2.
Now, beneficiaries are no longer stuck with that decision. Whoever is beneficiary on Dec. 31 of the year following the account owner's death is entitled to spread annual withdrawals over his or her lifetime. That means a young heir--say, a 5-year-old grandchild--can take payouts over 76.6 years.
If you have multiple beneficiaries, make sure to specify how you want the account divided. As long as your heirs split the account by Dec. 31 of the year after your death, each can base withdrawals on his or her own life expectancy rather than that of the oldest heir.
The new rules can help even those who already have inherited IRAs. If you are withdrawing money based on the life expectancy of an account owner who is deceased, you can switch to your own life expectancy with your next distribution, says Don Roberts, a spokesman for the IRS. But if you liquidated the account more than 60 days ago or are draining it over a five- year horizon, you're probably out of luck. Check with an expert.
Whereas the old rules often forced IRA owners to choose between providing for a spouse and extending their account's life by giving it to younger generations, the new rules allow those who plan carefully to achieve both goals. The key is to create at least two levels of beneficiaries. Then, inform the primary heirs of their right to disclaim, or renounce, their inheritance in favor of those with contingent, or secondary, status within nine months of the IRA owner's death. "Disclaimers are going to be huge," says Steven Lockwood, a co-author of the Individual Retirement Account Answer Book. "That's where all the action is going to be."
PATIENCE PAYS. Disclaimers have long been used by heirs who don't need a windfall and want to pass it on to others. For example, if a spouse needs only $500,000 of her husband's $750,000 IRA, she can renounce $250,000--in effect, handing the money to the contingent beneficiary. Say that person is her teenage grandson. The disclaimer causes the inheritance to skip a generation--and, quite possibly, two layers of estate taxes.
The new rules, however, create an additional incentive to disclaim because they free the next-generation heirs from the withdrawal schedule selected by the account owner. In the above example, this allows the grandson to spread payouts over his own life expectancy.
The benefit is dramatic. In fact, assuming an 8% annual rate of return, an 18-year-old inheriting $250,000 would realize $7.85 million of income over his lifetime--provided he takes only the minimum amount required, Fry says. "You are now assured that these accounts, if planned for properly, can stay in the family for two generations or longer," Lockwood says.
Whatever you figure on doing, make sure to name at least one primary and one contingent beneficiary. If you leave the form blank, your plan may name your estate by default. That would prevent those who inherit the money from taking advantage of the opportunity to spread withdrawals over their own lifespans. Given how much simpler the new IRS rules are, there's no excuse for making mistakes--never mind one that costs your heirs so much in forfeited investment gains.
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By Anne Tergesen