Income Tax Consequences
There are many types of retirement accounts that could have been established by your employer. Your employer might have made all of the contributions to the retirement account on your behalf, or you might have made some of the contributions. The way withdrawals by you or by your beneficiaries will be taxed depends on when the plan was set up, who made the contributions, and how the contributions were characterized when they were made. It is impossible to make a blanket statement about how the withdrawals from an employer-provided plan will be taxed. You need to contact your plan administrator and ask.
Usually an employer-provided retirement plan can be transferred to your traditional IRA after you retire. Again, you'll need to contact the plan administrator to determine your options. You may find more flexibility in your planning to transfer any employer-provided retirement plan into your individual IRA.
IRAs and annuities, on the other hand, are all governed by the same IRS rules. It doesn't matter who you have chosen as administrator to hold your IRA or annuity accounts. There is one set of rules for taxing withdrawals during your lifetime, and a second set of rules about the way withdrawals will be taxed to your beneficiaries after you are gone.
Income Taxes When You Withdraw
If you are over 59½ when you begin your withdrawals, those withdrawals from your traditional IRA or annuities must be reported on your income tax return, at your current tax rate, in the year you withdraw the money. There are no special income tax rates available for your withdrawals.
Taxation of Traditional IRAs
You must begin taking withdrawals from your traditional IRAs no later than the year you turn 70½. The amount you must withdraw each year is established by an applicable divisor schedule that has been established by the IRS. For instance, when you are seventy-two years old, that divisor is 25.6. You must total the value of all your IRAs with all administrators and divide that value by the divisor. For example, if your IRAs are worth $100,000, you must withdraw $3,906.25 ($100,000 divided by 25.6). The following year, when you are seventy-three years old, the divisor becomes 24.7 and you repeat the process. Each year thereafter, the divisor will decline. This annual reduction in divisor is to help stretch out the IRAs to last over your lifetime, but leave nothing remaining at your death.
If you are still under 70½, in order to allow the tax-deferred accounts to continue to grow, try taking withdrawals from an asset that does not give a step-up in cost basis, such as annuities. If you find you don't need the required distribution in the current year, you can reinvest that sum or add it to your taxable portfolio. By continuing to invest in your retirement years, you will provide security for yourself and possible additional assets for your heirs.
If you are uncertain about the math, each IRA administrator can make the calculation for your required minimum distribution from the holdings it administers for you. Each account is valued as of December 31 of the prior year.
If you are married and your spouse is more than ten years younger than you, you may elect to have your IRA paid over the joint life expectancy of you and your spouse. This election will result in a lower or smaller annual distribution. With a smaller annual withdrawal, you may be able to spread out your IRA benefits to last for the rest of your life and your spouse's life.
If you would like more information about how to make the calculations and determine how much you must withdraw each year, check the required minimum distribution section of IRS Publication 590. The required minimum distribution rules for tax-deferred accounts are complicated. IRS Publication 590 is dedicated to Individual Retirement Arrangements (IRAs) and retirement plans. You should request and review this publication carefully. Check out which circumstances apply to you and your beneficiaries before taking any withdrawals.
Taxation of Roth IRAs
If you have been purchasing Roth IRAs in addition to or instead of traditional IRAs, there will be no income tax when you begin withdrawals. Roth IRAs are established from funds on which you have already paid income tax, and they do not fit in the tax-deferred category.
If you have more than one IRA or annuity, it is not necessary to take a proportionate share of the required minimum distribution from each of your accounts. You can total all your tax-deferred accounts, but take the full required minimum distribution from just one account.
Because there is no income tax upon withdrawal, Roth IRAs are ideal for passing assets to your family. If you are eligible to create a Roth, it is worth considering establishment of a Roth account no matter what your age. Although there is no income tax due when withdrawing funds from a Roth, the value of your Roth is included in your taxable estate.
Taxation of Annuity Payments
An annuity is similar to an individual retirement account, but it has some quirks that make it an uncertain estate planning tool. While you are living, the earnings from the annuity are not subject to income taxes. But as soon as you withdraw funds or receive an annual payment, you will pay income taxes on the earnings.
One advantage to the annuity is that the initial amount you paid for the annuity is not taxed because you already paid tax on those funds. If there are annuity funds remaining in your estate at death, you might think that your heirs would be getting some benefit by having to report only the earnings. There is a drawback, however; see the section on Estate Tax Consequences later in this chapter.
Income Taxes for Your Beneficiaries
Withdrawals your beneficiaries make from your traditional IRA or annuity after you are gone are taxed in the same manner as withdrawals you might have made while you were alive. Thus, when your beneficiary makes a withdrawal from a traditional IRA, he will report that withdrawal on his income tax return at his income tax rate.
The rationale for making you take distributions from your IRA when you reach age 70½ is to try to force you to spend all of your IRA before you die — and to pay IRS the taxes. This is why the required minimum distributions are calculated based on your life expectancy.
IRAs can be divided into separate shares for each of your named beneficiaries. The life expectancy of the youngest beneficiary is used to calculate how quickly all of the beneficiaries must take their distributions. Check the IRS life expectancy tables in IRS Publication 590 to determine how rapidly your beneficiaries must withdraw from the IRA after you are gone.
The beneficiaries will need to withdraw a stated percentage each year. However, because the stated percentage is based on the life expectancy of the youngest beneficiary, the length of time over which the beneficiaries must withdraw is extended dramatically. Check the IRS brochures listed in Appendix B for further details on calculating the annual required distribution.
There is one major difference in income taxation between IRAs and annuities: The beneficiaries of your annuities pay income taxes only on the growth or gain on the annuities. With a traditional IRA (but not a Roth), your beneficiaries pay income taxes on 100 percent of the IRA distributions they receive after you are gone.