Most of us think of IRAs and retirement plans as financial tools for asset
accumulation. We often pay little attention to how funds can be withdrawn
from the accounts until retirement. Here are some general rules on how funds
coming out of IRA accounts are treated for income tax purposes. This
discussion applies to regular IRAs since "Roth IRAs" are treated
very differently. You may want to consult your tax advisor or more details or
to determine how specific rules would apply to you.
Distributions before age 59 ½
The general rule is that funds withdrawn from an IRA qualified plan before
age 59 ½ are subject to an additional tax of 10% on top of being
reported as taxable income in the year taken. In addition, there is a special
rule that can be applied for distributions taken using a life expectancy
formula that will also avoid the penalty. There are a few exceptions for
death and disability.
Distributions from age 59 ½ to age 70 ½
Once you reach age 59 ½, you can then start withdrawing funds
without penalty. You can withdraw any amount from zero to the entire amount
in the IRA. Withdrawals you take are subject to income taxes. If you are
still working or do not need the funds, you will probably leave them in the
account and continue to earn tax-deferred returns as long as possible.
Distributions after age 70 ½
After you reach age 70 ½, you must start taking distributions from
your plan. This forced distribution concept was established to eliminate the
possibility of someone accumulating huge amounts of money that continued to
grow tax-deferred. The IRS has also established rules to force you to take a
minimum amount each year. This is called the Required Minimum Distribution
(RMD). There is a more detailed discussion of RMDs below. You can also take
more than the minimum. Withdrawals you take are subject to income taxes.
Distributions at death
The beneficiary designated as part of your IRA will determine whom the
funds in your IRA pass to when you die. This transfer is not governed by your
will. If you designate your estate as the beneficiary, funds would then be
available to be distributed according to your will. This is also the case if
you have no designated beneficiary. That distribution triggers the income
taxation of the funds in the IRA.
If you designate your spouse or another person as the beneficiary, the IRA
passes to that person "intact" without being subject to income
taxes. It then gets treated like that person's IRA subject to the normal
distribution requirements (pre-59 ½, 59 ½ to 70 ½ and
after 70 ½).
Required Minimum Distributions
At age 70 ½, the IRS forces you to start taking withdrawals. These
withdrawals are often referred to as Required Minimum Distributions (RMDs).
The amount that must be withdrawn is based on the life expectancy tables
provided by the IRS. The rules for determining how much you must take were
simplified in early 2001. A uniform new life expectancy table was adopted and
generally provide for smaller RMDs.
If you are currently required to take RMDs, you should consult your tax
advisor to determine how the new rules apply and whether you should make
changes in your distribution levels. These new rules are called
"proposed" rules and technically do not apply until 2002. However
most experts believe they can be relied on for distributions during 2001.
Summary
Individual Retirement Accounts can be the foundation of a successful plan
for a financially secure retirement. Tax deferral on the earnings and the new
beneficial rules for required minimum distributions make these accounts even
more attractive. Some of the rules are complex, especially concerning
distributions, and a thorough discussion with your tax advisor can help you
understand your options.
