It has been said that there are two things you should never watch while they are being made: one is sausage and the other is tax law. Historically, this has been especially true of the rules and regulations governing the distributions from retirement funds, whether Individual Retirement Accounts (IRAs) or defined contribution plans (think 401k). For simplicity sake, when I refer to Retirement Plans (RPs), I am referring to both.
Why does the IRS have such an interest in your RP distributions? Well, in the words of famous bank robber Willie Sutton, "That's where the money is." A lot of it, too!
In fact, according to the Urban Institute, some $9.5 trillion was held in RPs at the end of 2012 alone.
The fundamental purpose of any RP is to help taxpayers send some of today's dollars ahead for tomorrow's retirement. Interestingly, however, RPs were never intended as financial vehicles to build large estates for heirs. This has been a nice "unintended consequence" for taxpayers and their progeny. (And the IRS isn't happy about that.)
So, how did that happen?
To facilitate their fundamental purpose of encouraging you to send money ahead for your own retirement (so you will not need to rely on Social Security alone), RPs enjoy preferential tax treatment during their creation and as they accumulate until distribution. They are created with pre-tax dollars and then grow tax-deferred. Consequently, through the tax-deferred compounding of their interest and dividends each year, RPs often grow to produce rather impressive account balances.
In fact, according to urban legend none other than Albert Einstein declared that "compound interest is the most powerful force in the universe." Regardless whether he actually said that, the fact remains: Especially in a tax-deferred environment, compound interest is quite a wonder.
Because of their preferential tax treatment on the front end (and while compounding tax-deferred), all distributions from RPs are fully taxed as ordinary income. Here is where taxpayers and the IRS have competing goals.
Taxpayers want to delay distributions from their RPs and enjoy the tax-deferred compounding as long as possible. The IRS, on the other hand, wants to see taxpayers take distributions faster and thus pay more taxes on the distributions at ordinary income rates.
Unfortunately, the IRS writes the rules and regulations.
As with everything it touches, the IRS seeks to control taxpayer behavior through a system of carrots and sticks. Carrots to reward and sticks to punish. During your working years you are given the IRS carrot of pre-tax contributions (oftentimes with an employer contribution to boot) to your RP. Thereafter, your RP enjoys another IRS carrot as it grows exponentially by compounding in a tax-deferred environment. [Ergo the insightful observation noted above, as attributed to Albert Einstein.]
So much for the carrots, now for the sticks.
Here is a little "grammar school" on two sticks the IRS holds to keep you in check regarding your RP. Remember these sticks as: 1) too soon; and 2) too late and/or too little. A basic understanding of these two sticks concepts is essential to avoid avoidable IRS penalties regarding RP distributions.
First, absent very limited exceptions, any distribution you take from your RP prior to age 59½ will subject you to a 10% excise tax in addition to the tax on the distribution itself.
Teaching point: You cannot access your RP too soon.
The funds are intended for your retirement later, not a new bass boat now.
Second, without exception, you must begin taking Required Minimum Distributions (RMDs) no later than your Required Beginning Date (RBD). Every IRA owner has but one RBD. That date is April 1 of the calendar year following the year during which the IRA owner reaches age 70½. After taking your RMD no later than your RBD, you must take subsequent RMDs by December 31 each and every year thereafter.
The penalty for non-compliance is stiff.
The RP owner must not only pay income taxes on the full amount that should have been distributed by their RBD, but also an additional excise tax of 50% on the RMD amount that should have been distributed but was not. And the 50% excise tax applies in any year in which at least the required RMD was not taken.
The RMDs are the minimum distributions an IRA owner must take each year according to an annual calculation. How are RMDs calculated for the retirement plan owner? A surprisingly simple calculation, actually.
The IRA balance as of December 31 each year is divided by the remaining life expectancy factor of the RP owner for the next year. The resulting amount is that which must be distributed … at a minimum over the following year.
Virtually every RP owner uses the Uniform Life table to recalculate his or her RMD each year. An exception is an RP owner whose spouse is more than 10 years younger. Such an RP owner may elect to use the more favorable of either the Uniform Life table or the IRS Joint Life and Last Survivor Expectancy table.
Teaching Point: Start your distributions when required and withdraw at least what is required every year thereafter.
While the IRA owner is alive and "retired" (however he or she defines it), the focus is on retirement distributions. As discussed above, you must take at least the RMD each and every year or pay the penalty. But what if there is more money left in your RP after you are gone and after your spouse, if any, is gone? What then?
Likely, you worked hard over many years to earn and grow your RP. Wouldn't it be a shame to have those who inherit your RP squander it on depreciating consumer goods and fleeting "experiences"? Let's face it - your hard-earned RP could be blown in the proverbial "New York minute" without very, very careful planning.
The difference between your beneficiary taking only RMDs each year and "cashing out" upfront is, well, impressive.
Perhaps an illustration will help make the case.
For purposes of illustration, we will assume the following facts:
Prodigal withdraws the entire RP in the first year. That is a big day for the IRS, as it inherits 36% of the $500,000. After 30 years, having paid the upfront tax hit and then investing the net after-tax amount (i.e., suspending reality because he really "invested" it all on wine, women and song), Prodigal would have $1,517,000 in year 30.
On the other hand, Responsible withdraws only the RMD each year using the life expectancy payout method. After 30 years, the Responsible would have $1,696,000 remaining inside the RP and after-tax investments of $1,432,000 outside the RP in year 30. That is huge!
Consequently, absent a true emergency, it is only prudent to arrange for your beneficiaries to withdraw only the annual RMD. But how do you do that?
Many RP owners name their children as the direct beneficiaries. While this approach may work just fine and allow each beneficiary to "stretch" RMDs over his or her respective lifetime, there are two hidden dangers awaiting the unwary: 1) the beneficiary could "cash out" the RP like Prodigal; or 2) the beneficiary could have it "taken away" by creditors and predators based on the U.S. Supreme Court decision in Clark v. Rameker, 573 U.S. ____ (2014).
After the Clark decision, any inherited RP is fair game for the creditors and predators of a beneficiary unless protected by a state exemption statute. Think divorces, lawsuits and bankruptcies when you think of the typical creditors and predators.
When RP owners realize the risks inherent in designating adult children as direct beneficiaries, many designate their living trust or the testamentary trust under their last will as the direct beneficiary. I think the IRS realizes this is a common alternative. As a result, the rules governing when a "trust" qualifies as a "designated beneficiary" on behalf of the "trust beneficiaries" are some of the most tortured in the entire tax code. Bar none.
Remember my "sausages and tax law" analogy? Case in point.
Knowing that responsible taxpayers will try to protect their RPs from and for their children, the IRS makes it extremely difficult for those taxpayers to provide for the maximum "stretch" when a "trust" created under a living trust or last will is the beneficiary of choice.
If you are finding all of this a bit confusing, then you are not alone.
When you are accumulating your RP and then taking withdrawals from it in retirement, you are working closely with your financial advisor to ensure the best strategy to maximize your overall return and minimize your overall tax bill. At the same time, make sure you have an estate planning strategy for the eventual inheritance of your RP.
Depending on each unique client situation, we may recommend designating adult children as the direct beneficiaries, designating trusts created under a living trust or a last will, or we may create state-of-the-art "stand-alone IRA inheritance trusts" for each beneficiary (even for each grandchild, in some circumstances).
Regardless, we have a process to stay in ongoing contact with you to revisit and revise as needed to meet your objectives as "life happens" to you and your loved ones.
Teaching Point: The estate planning for your RP should be as carefully considered as the rest of your estate plan.
There is simply too much at stake.
This has been a brief overview of an extremely complex subject. Remember: Take no action without consulting qualified legal counsel. The appropriate application of relevant laws will vary depending on the unique facts presented.
There are three ways to schedule your consultation: first, give us a call, second, send us an email or third, Request a Consultation online. It is that easy. Really.