This week, Gail explains how some new rules and an easier "stretch" can take the pain out of IRA withdrawals — and why "Slow Payor" sounds better than "Bankrupt."
I thought under the new tax laws for IRAs this year, a non-spouse would not have to immediately begin taking withdrawals. Am I wrong?
Hi, Lana —
I believe you're referring to the new Required Minimum Distribution (RMD) rules issued by the Internal Revenue Service in January. These (technically, they're "proposed") rules greatly simplify the withdrawal process for both IRA owners and those who inherit an IRA. The three different, complex calculation options we had been using for 13 years are now replaced with one simple, uniform method to figure out how much you must withdraw from you IRA once you hit age 70 1/2.
Starting this year, you can compute your RMD by dividing your IRA balance at the end of the previous year by a life expectancy factor — a number conveniently provided by the IRS. This "factor" is really the life expectancy of the IRA owner plus a beneficiary. For the sake of uniformity, it's assumed the beneficiary is ten years younger than the IRA owner.
Since the combined life expectancy of two individuals is longer than the life expectancy of one, the divisor will be larger than many people have been using. This means IRA owners who are over age 70 1/2 will be able to reduce the amount they're required to withdraw. You can look up the factor which corresponds to your age at the IRS Web site, http://www.irs.gov.
Everyone the same age will use the same divisor. For instance, all 70-year-olds will divide by 26.2. The only exception to this situation is when the IRA beneficiary is a spouse who is more than ten years younger. In this case, you go to the Joint Life Expectancy tables provided by the IRS either on its Web site or in Publication 590. Here you will find that the "factor" is even larger than the standard table. So your Required Minimum Distribution will be even smaller.
This new calculation method is optional for 2001 RMDs. If you're really fond of the old, archaic ways of figuring in this out, this is your last year to use them. Next year, all IRA owners over age 70 will have to use the new method. Frankly, since most will see their required withdrawals decrease and, thus, owe less income tax, I can't think of a sane reason not to adopt the new, simpler approach.
The new RMD rules also vastly improve the situation for beneficiaries. Under both the old and new rules, a spouse — and ONLY a spouse — who inherits an IRA has the option of rolling it over into his/her name. In this case, the beneficiary becomes the IRA owner, and if he/she is under 70 1/2, no withdrawals are required yet — even if the deceased spouse had already started them. Instead, the IRA can remain invested and the tax deferral advantages continue until such time as the surviving spouse reaches age 70 1/2 and must begin RMDs.
The regulations are different if the person inheriting the IRA is not a spouse. However, here, too, the situation is vastly better than before. That's because every beneficiary now has the opportunity to "stretch" the IRA withdrawals over their own life expectancy, thereby extending the years of tax-deferred growth. The difference between "stretching" an IRA versus taking a lump sum out can literally amount to thousands of — and even more than a million — dollars. Non-spouse beneficiaries often could not get take advantage of "stretch" IRA withdrawals under the old rules because it depended upon how the IRA owner had arranged his/her Required Distributions. If Dad chose to calculate RMDs based on his life expectancy alone, when his daughter inherited it, she usually had to cash it out and pay all the taxes due at once.
To see the advantages of stretching withdrawals, let's assume Mom dies with an IRA worth $300,000 — not out of the question when you consider most people roll their 401(k) balances into an IRA when they retire. Each of her two sons inherits half her IRA, or $150,000 apiece. Assume Son #1 is 40 years old and decides to cash out his stake. After taxes at 28% he walks away with $113,644.
Son #2, however, decides to defer gratification and "stretch" out the life of his mother's IRA. Since he is a non-spouse beneficiary, he must begin withdrawals by December 31, the year after the IRA owner's death. (Caution! Even non-spouse beneficiaries of Roth IRAs must adhere to this deadline.) However, since he is 45 years old, he is allowed to extend the withdrawals over his life expectancy of 37.7 years. The first year, the minimum he has to withdraw is roughly $4,000, leaving the bulk of his mother's IRA intact.
Now, assume that his mom's IRA grows tax-deferred at an annualized rate of 8%. If Son #2 continues to withdraw only the minimum amount required each year, at the end of 37.7 years he will have received a total of $1,007,042! Even when you factor in the income tax Son #2 has to pay, it's clear he ends up with far more than his cash-hungry brother.
By the way, if Mom had converted her traditional IRA to the Roth variety, both sons would have received their income free of federal income tax!
It's extremely important that IRA owners and their beneficiaries understand how to use the new regulations to maximize the life of this unique asset and minimize the tax consequences. Who you choose to be your IRA beneficiary has taken on greater importance. Make sure you have also name contingent beneficiaries, as well. I strongly suggest you discuss your options with an experienced financial advisor. This is one of those rare "gifts" from the IRS that is too good to pass up!
Best wishes —
With respect to your comments on using Consumer Credit Counseling, it is my understanding from a bank loan officer that if CCC alters the normal interest rates due on an account, it will have an adverse effect on your credit rating. Can you verify the ramifications of using CCC. Nothing usually comes for free.
You are referring to the article I wrote on July 14 titled "Digging Out of Debt." (Click on "Archive" on the right-hand side to access this.) When Consumer Credit Counseling agrees to intercede with creditors on behalf of someone over their head in debt, it is as a last-ditch effort to help them avoid bankruptcy. As I explained, although CCC negotiates a slower repayment schedule, they do not ask creditors to reduce the amount which is owed.
Creditors are certainly allowed to enter relevant comments into an individual's credit record. However, a notation that the individual sought help in re-paying their debt from CCC is much more positive than "bankrupt" because it indicates that person didn't take the easy way out. It also demonstrates that the individual is making an honest effort to be both more responsible and more disciplined in the way they handle money.
On the other hand, filing for bankruptcy is a stain on your credit rating for ten years. In the eyes of a creditor, there's nothing positive about that.
Which would you prefer?
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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.