Avoiding Pitfalls When Forced to Start Breaking Your Retirement Piggy Bank

April 8, 2016

The first of the 75 million baby boomers began turning 70 this year (2016).  Becoming a septuagenarian is a milestone in itself, but it also means that soon the IRS will likely be expecting you to start cashing out your tax-deferred retirement savings that you may have spent decades building up.

If you don’t start taking what are called required minimum distributions (RMDs) from your non-Roth individual retirement account (IRA) or 401(k) accounts and pay taxes on the withdrawals, you will face a 50 percent penalty on what should have been withdrawn but wasn’t.  But more than this, how you structure these distributions can have a profound effect on your own retirement and on what you leave your heirs.

Congress created the rules governing the minimum distribution of retirement plan funds to encourage saving for retirement and to allow retirement assets to build up tax-free during the plan owner’s working years. You do not pay tax on income you put into a tax-deferred retirement plan when earned or on investment income or gains on the account itself. However, the funds you withdraw upon retirement are treated as taxable income in the year you take the distribution. And if your children withdraw the funds from a tax-deferred account that they inherit from you, they will be taxed on such distributions at their income tax rates.

Not everyone with a retirement account must take RMDs, however.  Usually, employees who are still working can, if their plan allows, wait until April 1 of the year after they retire to start receiving these distributions, as long as the employee doesn’t own at least 5 percent of the company.  (You still have to take RMDs from SEP or SIMPLE plans, although you can continue contributing to them as well.) Also, funds invested in a qualifying longevity annuity contract (QLAC) are not counted in calculating your regular RMDs and distributions are not required until age 85.

When to Start the Withdrawals?

The first decision seventy-year-olds have to make is when to begin their RMDs.  Ordinarily, your RMD must be made by December 31 of each year.  But recognizing that people may need some extra time to adjust to this new landscape, the IRS allows you to defer your first RMD until April 1 of the year following the year you turn 70 ½.  Those who will turn 70 in the second half of the year will be 70 ½ in 2017, which means they can wait until April 1 of 2018 to make the withdrawals.  (If you turn 70 in the first half of 2016, you must make the withdrawals by April 1 of next year.)

But waiting as long as possible may not be in your interest.  If you delay until April 1 of the year after you turn 70 1/2, you could have a hefty tax bite because you would have to take your second-year distribution by December 31 of the same year. This additional income could push you into a higher tax bracket for that year and also affect the tax that might be due on your Social Security benefits and maybe even increase your Medicare tax for the following year if your income rises above $200,000 (for single filers; 2016 figure).

Making the Calculation

You must withdraw a small percentage of your tax-advantaged retirement savings each year after age 70.  The exact amount for a year is determined by dividing the fair market value of your retirement account(s) as of the previous year’s end by the applicable distribution period. A simple chart gives your distribution period in years. If, for example, you had $100,000 in a retirement account on December 31 of last year and you were 73 as of that date, you would have to withdraw $4,049 from the account by the end of this year ($100,000 divided by your distribution period of 24.7 years).

The distribution period is different if the sole beneficiary of your IRA is your spouse and he or she is more than 10 years your junior.  In this case, consult the “Joint Life and Last Survivor Expectancy” table in the Appendix of the IRS’s Publication 590. To see this publication, go to: https://www.irs.gov/pub/irs-pdf/p590b.pdf.

Also, just because you missed a required withdrawal or didn’t withdraw enough doesn’t mean you’ll automatically get hit with the 50 percent penalty.  You can ask the IRS to waive the penalty by filing Form 5329 with your tax return, saying that you were confused or had poor financial advice.

Advance Planning Helps

Planning in advance can help you avoid ending up in a higher tax bracket or paying higher Social Security or Medicare taxes once you start taking your RMDs.  One strategy is to convert some of your retirement funds to Roth IRAs in years prior to turning 70.  The RMD rules do not apply to the Roth IRA owner, although you will pay taxes when you convert. The ideal time to convert would be after you retire and may be in a lower tax bracket.  You can also, of course, start making withdrawals from tax-deferred accounts early, before you are required to do so, as long as you have reached at least age 59 ½.

Another technique is to make a qualified charitable distribution (QCD). Investors aged 70 ½ or older may transfer as much as $100,000 a year from an IRA directly to a charity without having it count as taxable income.  A QCD can be used to meet part or all of an RMD obligation (as long as it’s less than $100,000) and no income tax will be due on the withdrawal.

Managing your RMDs can be a tricky proposition, particularly for those with multiple accounts.  You want to avoid pushing yourself into a higher tax bracket, but you also don’t want to under-withdraw and face a 50 percent penalty or miscalculate your year-end account balance because your account custodian wasn’t aware of current year recharacterizations and conversions. For these reasons, it’s a good idea to consult with a financial advisor or your elder law attorney well before crossing the threshold into RMD land.

For ElderLawAnswers’ article on taking money out in retirement, click here.

For an IRS article on RMDs, click here.

As referenced by the links in the above article, the website Investopedia has many articles on RMDs.  Here’s a basic one.

For more on retirement planning, click here.

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What Is Undue Influence?

Saying that there has been “undue influence” is often used as a reason to contest a will or estate plan, but what does it mean?

Undue influence occurs when someone exerts pressure on an individual, causing that individual to act contrary to his or her wishes and to the benefit of the influencer or the influencer’s friends. The pressure can take the form of deception, harassment, threats, or isolation. Often the influencer separates the individual from their loved ones in order to coerce. The elderly and infirm are usually more susceptible to undue influence.

To prove a loved one was subject to undue influence in drafting an estate plan, you have to show that the loved one disposed of his or her property in a way that was unexpected under the circumstances, that he or she is susceptible to undue influence (because of illness, age, frailty, or a special relationship with the influencer), and that the person who exerted the influence had the opportunity to do so. Generally, the burden of proving undue influence is on the person asserting undue influence. However, if the alleged influencer had a fiduciary relationship with your loved one, the burden may be on the influencer to prove that there was no undue influence. People who have a fiduciary relationship can include a child, a spouse, or an agent under a power of attorney. For more information on contesting a will, go here.

When drawing up a will or estate plan, it is important to avoid even the appearance of undue influence. For example, if you are planning on leaving everything to your daughter who is also your primary caregiver, your other children may argue that your daughter took advantage of her position to influence you. To avoid the appearance of undue influence, do not involve any family members who are inheriting under your will in drafting your will. Family members should not be present when you discuss the will with your attorney or when you sign it. To be totally safe, family members shouldn’t even drive or accompany you to the attorney’s office. You can also get a formal assessment of your mental capabilities done by a medical professional before you draft estate planning documents. For more information on preventing a will contest, go here.

July 14, 2016

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