Retirement is a time of big adjustments. After having spent a lifetime going to work every day and building a regular routine, suddenly you find yourself with a lot of time on your hands and the flexibility to do whatever you want with it. At the same time, you also have to cope with no longer earning a salary and with living on the fixed budget that Social Security, an employer pension, and the interest and dividends from your investments provide.
One of the habits that seniors often find hard to break has to do with their retirement plans. After being told countless times during their careers that they should contribute as much as they can toward their retirement, many seniors have a great deal of trouble persuading themselves to start taking withdrawals from their retirement accounts. With traditional retirement accounts, however, you can't just leave your money untouched forever; the IRS has rules that require you to start taking withdrawals at a certain point even if you don't want or need the money. The penalties for breaking these rules are severe, so it's prudent to follow them.
Required minimum distributions
Because the purpose of IRAs and employer-sponsored retirement plans is to help people save for retirement, Congress set up the tax laws to make sure that people didn't use them solely for other purposes, such as building a nest egg to pass on to their heirs. While Congress was willing to give savers a tax incentive to contribute to their retirement accounts, it also wanted to make sure that the money in those accounts would be subject to tax at some point in the future. The required minimum distribution, or RMD, rules make sure that people actually take out some of the money in their retirement plans after retirement.
The rules require that you begin taking distributions from your retirement accounts when you turn age 70 1/2. During the first year of distributions, you have until April 1 of the following year to withdraw the correct amount. So for example, if your 70th birthday is today, then you have until next April to make your required withdrawal for 2007.
To figure out how much you need to take out of your retirement accounts, you have to use special life expectancy tables issued by the IRS. The RMD amount is a fraction of your account assets based on your current life expectancy. For instance, if you turn 70 today, then your life expectancy according to the IRS tables is 27.4 years. If you had $100,000 in all of your retirement accounts at the end of 2006, then the amount you must take out for 2007 is $100,000 divided by 27.4 or about $3,650. It's important to check and double-check your calculations, because the penalty for not having enough money withdrawn from your retirement accounts is a hefty 50%.
As you can see, the amount you have to withdraw is relatively small in comparison to your total retirement assets. As you grow older, however, that fraction increases. By age 79, the formula requires you to take over 5% of your account value each year; at age 92, the withdrawal amount is almost 10%. Because your remaining account balance will likely grow faster than you're taking money out during the early years of your retirement, you can expect the amount of your required withdrawals to grow steadily for at least the first 10 to 15 years of distributions.
If you don't need it
If you've managed to save more than you actually needed for your retirement, then you may be in a position where you don't need the money in your retirement accounts. You may not be happy about the tax impact that RMDs have, forcing you to treat distributions as income. Depending on your secondary goals for your retirement money, there are a few alternatives you may have.
First, you need to figure out what you want to happen to the money in your retirement accounts. If you're interested in making substantial charitable gifts, then you can take advantage of a new provision in a 2006 law that allows you to donate up to $100,000 to charity directly from your IRA. While you won't be able to deduct your donation on your taxes, you also won't have to include the distribution in your taxable income. Any charitable distributions counts against your RMD amount, so if you give enough money to charity, you won't have to withdraw any more during the year. The charitable provision is set to expire at the end of 2007, however, so this is a one-time deal.
Another way to avoid the RMD rules is to convert traditional IRAs into Roth IRAs. While you'll pay tax currently on the money you convert, you'll never have to pay taxes again once the money is in the Roth IRA. This is especially good if you plan to give this money to your heirs, because the Roth IRA provisions allow for your heirs to maintain the account's tax-free status throughout their lifetimes as well. Best of all, Roth IRAs don't have any RMD rules, so you'll never have to worry about calculating the right amount to withdraw.
Retirement accounts are useful tools to help you save. After a lifetime of financial success, retirement is the time to reap the benefits of your hard work. Understanding and managing your distributions is essential to making the most of your hard-earned money.
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