The age of 70½ is the age at which you must begin taking distributions from your qualified retirement accounts and Individual Retirement Accounts (IRAs). These required distributions present several planning opportunities and pitfalls. The tax rules are complicated and the consequences can cost you or your beneficiaries thousands of dollars in unnecessary tax bills.
There are two main reasons why it is important to plan correctly for this time in your life. First, it is to your advantage to take the smallest distributions allowable for as long as possible. The longer your retirement assets remain in a retirement account, the more you enjoy tax deferral and the more your account will compound. Second, your heirs may derive a larger after-tax benefit if the distribution options are properly selected. Tax deferral is still the name of the game, but you must take care to designate the correct beneficiaries and elect the optimal distribution methods. The decisions that you must make before you reach this age are very important. They affect the size of your distributions, your income and estate taxes, and the after-tax benefit to your beneficiaries.
One of the most important decisions you must make before you reach age 70½ is naming the person(s), or trust who will be your beneficiary(ies). These beneficiaries are referred to as your designated beneficiaries. Once you have chosen these designated beneficiaries and attained the age of 70½ , your required minimum distribution options are set and cannot be changed. You can still change the beneficiaries that will receive your IRA assets after this date, but the required minimum distributions will be calculated using the life expectancies of your designated beneficiaries for as long as you own the retirement account or IRA.
When choosing beneficiaries, what are the issues that should concern you?
- Choosing the optimal beneficiary or beneficiaries. When you choose younger beneficiaries, who have a longer life expectancy, you will have smaller required minimum distributions and you will leave more money in the retirement account for a longer period of time. The result of this action is to preserve the tax deferral advantage in your retirement account.
- Should I automatically choose my spouse as beneficiary? When you choose your spouse as beneficiary your spouse will have several options that yield a great deal of flexibility. However, there are situations where the obvious choice may not be the best choice. A trust might be a more advantageous choice. But be careful here, the trust language has to be carefully worded and all of the IRS qualification requirements must be met.
- Electing the optimal distribution method. There are two possible elections for the retirement plan owner and the designated beneficiary: period certain (locking in an actuarial age at the time distributions begin) or recalculation (recalculating your actuarial age each year using an actuarial table). Each election carries with it several advantages and disadvantages and must be considered in conjunction with your overall financial plan.
- Have I clearly communicated my choices and elections to my heirs? When your heirs understand your intentions they can benefit from your planning. For example, if you and your spouse have discussed the fact that the proceeds from IRAs would not be needed for the surviving spouse’s support and that the proceeds from your IRAs should be left to your children, the surviving spouse will be able to take appropriate action to see this strategy through to its completion.
What are the pitfalls that you should avoid?
- Avoid causing your IRA to be distributed in total within one year of your death. Besides the estate taxes that might be due on the transfer of your IRA to your beneficiary, there will be a large income tax bill created when the balance in the IRA account has to be distributed in one taxable year.
- Avoid causing your IRA to be distributed more quickly than is necessary. In many cases, the IRA owner does not need all of the distribution from the IRA that the law requires. In situations like this, the correct choice of beneficiaries and elections regarding the distributions can minimize the payout over time and preserve the balance in the IRA for a longer period of time.
- Do not automatically choose your spouse as beneficiary without considering all of the consequences. It seems to make sense to name your spouse as the designated beneficiary. However, this can create real problems if a spouse predeceases the IRA owner after the required minimum distributions have begun.
As you are nearing this stage of your life, please remember that there are financially significant decisions that must be made. These decisions are complicated and require the advice of competent financial advisors who specialize in estate and tax planning and who are capable of crunching the numbers. Please call us and let us help you through this process.