Long-term stock investors do their best to build up enough of a nest egg to live well during retirement. Yet when they finally reach retirement, many investors find that they have more than enough money from other sources. As a result, they often aren't in any hurry to take withdrawals from their retirement accounts -- especially since they have to pay taxes on those withdrawals.
Nevertheless, the IRS puts strict time limits on how long you can wait before taking out your money. Most of the time, that forces investors over age 70 1/2 to begin making withdrawals, or else they'll face huge penalties. But this year, the stock market crash may prompt the government to give some retirees a break from those mandatory distributions, although that's far from a sure thing at this point.
The benefits of tax deferral
If you're a well-to-do retiree, saving on taxes is extremely appealing. When you combine any pension income you may have, Social Security, and your income from investments, you may find yourself with larger tax bills than you ever expected you'd have. IRAs, 401(k)s, and other tax-favored accounts give you valuable tax deferral, giving you a chance to manage at least some of your tax liability.
Yet all good things must come to an end, and the tax benefit of retirement accounts is no exception. Once you turn 70 1/2, the IRS makes you start taking money out of these tax-favored accounts. Those withdrawals, which are known as required minimum distributions (RMDs), count as taxable income, and you'll pay income tax at your regular rate on them.
What's different this year?
The market's plunge has caused a controversy about RMDs. Here's the rub: The RMD amount is calculated as a percentage of your total account balance at the end of the previous year. That percentage is based on your life expectancy -- so roughly speaking, if the IRS tables indicate that you have a life expectancy of 20 years, you'll have to take out 1/20 or 5% of your account assets sometime before Dec. 31.
With the S&P having fallen nearly 50% for the year before Friday's big bounce, retirees who waited until the last minute to take their RMDs were put in a difficult position. Because many have lost a huge portion of their retirement savings, the amount of their RMD suddenly represents a much larger percentage of their total savings.
To put this in perspective, consider a simple example. Say you own 1,000 shares of seven different stocks:
|
Company |
Value of 1,000 Shares on Dec. 31, 2007 |
Current Value of 1,000 Shares |
|---|---|---|
|
Agrium (NYSE:AGU) |
$72,170 |
$26,470 |
|
Mindray Medical (NYSE:MR) |
$42,690 |
$14,800 |
|
Nasdaq OMX (NASDAQ:NDAQ) |
$49,490 |
$16,840 |
|
Petroleo Brasileiro (NYSE:PBR) |
$57,500 |
$17,400 |
|
Transocean (NYSE:RIG) |
$143,150 |
$57,080 |
|
UnitedHealth Group (NYSE:UNH) |
$58,150 |
$17,150 |
|
Dow Chemical (NYSE:DOW) |
$38,080 |
$17,380 |
|
Total Value: |
$461,230 |
$167,120 |
Source: Yahoo Finance. Current values as of Nov. 21.
As you can see, falling share values caused this portfolio to lose more than 60% of its value.
If you're age 78, the factor you use to determine your RMD is 20.3, meaning you'd have to withdraw about 4.9% (1 divided by 20.3) of your account balance. But because you have to use the Dec. 31 balance, the RMD amounts to $22,721 -- which is a much higher 13.6% of your portfolio's current value.
Many are upset at the prospect of having to sell a huge portion of their assets at market lows to cover their RMDs. That's led to a push among some to suspend the rule for 2008.
The fix
The possibility of suspending the RMD rule has put tax planning in limbo for those who haven't already taken their distributions. Time is running out, but at the same time, you don't want to add to your taxes unnecessarily if the rule gets changed.
The silly thing, though, is that the premise behind suspending the rule just isn't true. Even if you liquidate assets to make an RMD, you can just use the proceeds to buy back the exact same assets in a taxable account immediately thereafter. So if you think the market will rebound, you can just invest your withdrawal in the same stocks or funds you owned in your IRA.
Nevertheless, if you haven't made a withdrawal yet, you may want to wait a while longer. If lawmakers give retirees a free pass this year, taking advantage will let you put off taxes on that money for at least another year. With all the losses investors have seen this year, any way to reduce expenses is a good thing.
Here's more about finding the silver lining in a bad market:
- The biggest threat to our economy.
- Another attempt to destroy your retirement.
- Ways to rescue your 401(k).
