Online Extra: How To Dodge IRA Pitfalls (Extended)

Ed Slott talks tactics in taking distributions

For years, you've been stashing money in 401(k)s and individual retirement accounts. But soon after you turn 70 1/2, the Internal Revenue Service requires you to start liquidating most of these accounts. The rules are complex. And if you make a mistake, you could be hit with a 50% penalty on whatever you were supposed to take out but didn't.

The stakes are especially high now that banks and other IRA custodians are required to notify both you and the IRS when you're due for a distribution. To help you avoid costly missteps, BusinessWeek Personal Finance Editor Anne Tergesen spoke with IRA expert Ed Slott about common mistakes. Edited excerpts from their conversation follow. (Note: This is an extended, online-only version of the interview in the July 26, 2004, issue of BusinessWeek.)

Q: Why does the IRS require you to tap these accounts? And why at age 70 1/2?


The government wants to get its tax money. Remember that you received tax deductions all those years on your contributions. So the money in these accounts isn't all yours. Some of it belongs to the IRS and was essentially on loan.

Part of the benefit to these accounts is that you get tax deductions on your contributions during what are generally your high-earning years. Then, because income generally falls during retirement, when you pull the money out starting at age 70 1/2, you're theoretically subject to a lower tax rate. As for age 70 1/2, no one knows where that came from.

Q: What are some common mistakes people make when taking IRA distributions?


For most people, the date you're required to begin taking withdrawals is Apr. 1 of the year following the year in which you turn 70 1/2. So if you turn 70 1/2 this year, the IRS gives you until Apr. 1 of 2005 to start.

But it's a mistake to wait, because you'll have to take two distributions in 2005 -- one covering your first year of required distributions and the other covering your second. It's better to take your first distribution in 2004. That way you separate the distributions into two tax years and generally lower your income -- and your tax bill -- in each year.

Q: Can you delay distributions if you're still working at 70 1/2?


As long as you're still working, you don't have to take distributions from your employer's 401(k) plan. But when it comes to IRAs and 401(k)s from past employers, you can't escape. Once you stop working, the requirement to take money from your company 401(k) kicks in as well.

Q: If you have several accounts, do you have to take withdrawals from each?


If you have more than one IRA, add their balances. You can take a distribution from one account that covers all of them. It doesn't matter which IRA the money comes from -- as long as it's the right amount.

Be careful not to mix 401(k)s and IRAs this way, though, since the rules require you to take money from each. Likewise, a married couple can't take money out of one spouse's account to cover the other spouse's distribution. And with more than one 401(k), you've got to take separate withdrawals from each. I see these mistakes all the time.

Q: Are there any problematic investments?


Some people tie all their money up in certificates of deposit. As a result, they have to break into a CD early just to take their distribution and incur a penalty. CD rates are low as it is, so you don't want to lower your returns even more by paying a penalty on an early withdrawal.

Q: Anything else we should know?


You don't have to take distributions in cash. Say your required distribution is $10,000. If you own IBM stock in your IRA but want to hang on to it, you can transfer shares worth $10,000 to a taxable account and pay income tax on it. But when you sell the stock, remember that you already paid this tax, or you might accidentally pay the IRS twice.

Q: What if you make a mistake?


You're subject to a 50% penalty on the amount you should have withdrawn but didn't. If your required distribution comes to $10,000 and you miss it entirely, that's a $5,000 penalty.

Many times, the IRS waived the penalty in the past. But it may not be as lenient now. That's because starting this year, the banks, brokers, and other custodians holding IRA money are required to notify both you and the IRS when you're due for a distribution. Now that the IRS knows you got a notification, it may not be as lenient. Definitely, Big Brother is watching you on this.

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