Whoever said things don’t change for the better hasn’t heard about the changes made to IRAs this year.
With very little fanfare, the IRS is working to simplify the complex rules governing the required minimum distribution rules that affect everyone who has an IRA. These exciting changes can potentially reduce your taxable income and give you much more flexibility in passing retirement accounts to your family at your death.
Here’s what’s happening: Anyone who has a traditional IRA is required to begin taking withdrawals from the IRA when reaching age 70 & #733; , that hasn’t changed. What’s different is the IRS will now allow most people to take the IRA required minimum distributions using a longer life expectancy, which reduces the amount they need to take out each year.
Using these new rules, you could potentially reduce your required minimum distribution by as much as 40 percent and postpone thousands of dollars in taxes. This is fantastic news if you don’t use your IRA for living expenses and want to maximize the tax-deferred growth for yourself and your beneficiaries.
The IRS is making these changes effective next year but will allow you to use the new method for calculating this year’s required distribution, too. It’s important to see how these new rules may affect you because in most situations, the new calculations will result in a lower required distribution.
– Two Scenarios Illustrate Rules
To illustrate the new rules, let’s look at a couple of scenarios.
Scenario 1: A 75-year-old person names his estate as the beneficiary and has a year-end account balance of $100,000. Under the old rules, the required distribution for this year would be $8,000. Under the new rules, the required minimum distribution would be only $4,587.16, a reduction of almost 42 percent.
Scenario 2: This person is age 78, has a 77-year-old spouse named as the beneficiary and is in the 28 percent tax bracket. Based on a year-end account balance of $500,000 and a joint recalculation method, this couple has a required payout of $34,246.58 under the old rules. Now with the new rules, the required minimum distribution would be reduced to $26,041.67, which could mean a tax savings of over $2,200 in the first year alone.
The IRS is also changing how the beneficiaries of your IRA withdraw the money after you die. Under the old rules, the options beneficiaries had were difficult to understand and often limited.
Under the new rules, beneficiaries have the option to withdraw the money over their own lifetimes, which can minimize the impact of income taxes to them as well as continue the tax-deferred growth of their account. The effect of a lifetime distribution is dramatic.
Say your 38-year-old son inherits your IRA worth $500,000. He’ll generally have two choices: He can withdraw all the money from the IRA within five years of your death, or he can take an annual withdrawal from the IRA based on his life expectancy (44.4 years). By age 68, assuming he’s had an 8 percent rate of return, he would have withdrawn over $1.6 million dollars and still have over $1.7 million in the IRA to pass on to his heirs.
Returns are hypothetical, assume reinvestment of earnings, do not reflect the effect of commissions or fees, do not guarantee future results, and do not represent the returns of any particular investment.
If you intend to leave IRA money to your heirs, they need to know about these new rules, too.
– Other Side Of The Coin
So, is there a downside?
Financial institutions will now be required to calculate and report to the IRS the required minimum distributions for the IRAs they hold. The IRS will then be able to compare those amounts with what you actually took out of your IRAs that year. If you don’t take out enough, the IRS may be more likely to assess a penalty , 50 percent of the amount that was underdistributed. Ouch!
With that big penalty and big opportunity in mind, if you’re over age 70 & #733;, doing estate planning or are a beneficiary of an IRA, you’ll want to make an appointment with financial and tax advisers to see how you can put these changes to work for you.
Chiang is vice president/private client manager for Wells Fargo & Co. in San Diego.
