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Smart IRA withdrawal strategies
Knowing your income needs and options is key for minimum required distributions.
Every year, if you’re age 70½ or older, you generally need to withdraw a certain amount of money from your IRA, 401(k) plan, or other workplace savings plan. The withdrawals are required by the Internal Revenue Service.
Distributions from traditional IRAs (non Roth), are usually taxed as ordinary income, although part of these distributions may be nontaxable if you've made after-tax contributions to these accounts. While you‘re required to take these minimum required distributions—known as MRDs or RMDs—you have some flexibility on timing and what to do with the money. For instance, you may not need it for essential living expenses, so you may want to earmark it for heirs, grandchildren, or a charity. Note: Withdrawals may be nontaxable if they are made directly to a qualified charitable organization.
To come up with an MRD strategy that works for you, it helps to first understand the basics and then answer four key questions. Your answers will help you choose a strategy that makes sense for your financial situation.
Generally, your MRD is determined by dividing the prior year's year-end balance (the adjusted market value of your IRA as of December 31 of the previous year) by a life expectancy factor from an IRS table, typically the Uniform Lifetime Table.
The full amount of your MRD must be withdrawn from your IRA no later than December 31 each year. There's a powerful incentive to do it by that date: If you don't, you'll be hit with a 50% penalty on the amount you were supposed to withdraw but didn't. For example, say your MRD this year is $25,000, but you withdraw only $10,000. You failed to take out $15,000—so the IRS would fine you half that amount, or $7,500.
Those who are turning age 70½ can take advantage of a one-time delay in taking their MRD. They have the option of taking their first MRD no later than April 1 of the year following the year they turn 70½. But, should you choose to delay a distribution, be aware that you will have to take two MRDs in one calendar year—one that covers the previous year in which you turned 70½ and another for the current year. Both of these distributions may be taxable within the year they are taken. Roth IRAs are not subject to these MRD rules. They don't require minimum distributions during the lifetime of the original owner.
You can leave assets in a Roth IRA as long as you live, with no penalty.1 (Note: Designated Roth accounts in 401(k) plans do require minimum distributions. You can also delay taking MRDs from a 401(k) or other current employer's workplace savings plan if you continue to work beyond age 70½, provided you don't own more than 5% of the business you work for. In that case, you have until April 1 of the calendar year after the year in which you retire to begin taking MRDs.
MRDs and your retirement income plan
It’s important to determine how MRDs fit into your overall retirement income plan, especially if you need the cash flow to cover expenses.
Building a sound retirement income plan—one that can match your income sources with your expenses—is a critical component in achieving overall financial success during retirement. And, if you don't absolutely need the money, you can make some decisions about the best way to use the funds.
"Only one out of four preretirees has a written, personalized retirement income plan, much less a plan for managing MRDs, according to the Life Insurance Marketing and Research Association,"2 says Ken Hevert, Fidelity vice president of retirement products. "Taking the appropriate steps can help you make the best use of your savings and distributions—and help avoid costly mistakes."
You may not need your full distribution to meet essential expenses. In that case, you have some flexibility with the timing of your withdrawals and for reinvesting the money you pull from the account. And, if the distribution is taken in kind (shares distributed to a nonretirement account rather than cash) no reinvestment may be necessary. "You may have more control over these assets than you think," Hevert notes.
Four key questions to ask
1. Do you need the money to cover living expenses?
“If you’re planning to spend your MRDs, one big consideration is managing your cash flow,” explains Hevert. You may want to consider arranging to have payments sent directly to a cash management account that provides flexible access to the money with features such as checkwriting, ATM use, and online bill payment.
It’s important, however, to be aware of fees that may be associated with cash management accounts as well. The less money siphoned off in ATM or online banking fees, the more you’ll have to spend. Last, if you’re concerned about the security of your funds in a cash management account, consider using one that provides FDIC insurance on your deposits.
Arranging to have the funds automatically distributed to a cash management or taxable brokerage account also helps to ensure that your MRD requirement will be met by the deadline of December 31 each year, avoiding an IRS penalty on funds withdrawn after the deadline. When planning your budget, bear in mind that you’ll owe income tax on any MRDs and other withdrawals from traditional retirement accounts. You can have taxes automatically withheld from your MRDs. If you choose not to do this, make sure you set money aside for tax time.
There are a few different “systematic” withdrawal methods that you may want to consider to help you satisfy your MRD requirement:
2. Do you plan to reinvest the money?
Say you want to use the assets to help pay for college costs for a family member or friend. In this case, you can arrange for your MRDs to be deposited directly into a 529 college savings plan, although this will not avoid the tax due on the MRD. A 529 college saving plan helps to shield any future income and realized capital gains from annual taxes, and withdrawals are tax free as long as they're used for qualified higher-education expenses.
If you invest your MRD in a taxable account, you may want to arrange your investment strategy so the account holds tax-efficient securities. This approach may help minimize investment returns adding to your tax bill.
Meanwhile, you may want to consider investing the existing assets in your IRA or other retirement plan in investments that are not tax efficient, such as taxable bond funds, REITs, or short-term stock holdings. Whether you invest the money for your own purposes or for someone else's education, be sure to allocate the money according to investing fundamentals.
"Know what the purpose of the money is, how long until you'll need it, and how much risk you're willing to take—and invest accordingly," says Hevert.
3. Do you plan to pass assets on to your heirs?
When drawing up a will, you may want to consider your current tax rate applied to converted IRA assets versus the tax rate your heirs would pay on inherited assets. If your heirs will be in a higher tax bracket than your own then it may make sense to convert.
The Roth IRA's absence of minimum required distributions during the lifetime of the original owner means you can leave the assets in place for as long as you live, with the potential to generate tax-sheltered growth for future generations. Your heirs will have to withdraw a minimum amount each year after they inherit the account, but they generally won't be taxed on those distributions, which potentially increases the value of your bequest. You will have to take out any MRD amount first before you convert your remaining assets in your IRA to a Roth IRA. Note: While Roth IRAs are generally not subject to income tax, they are still subject to estate tax, so it is important to plan accordingly.
When you convert an IRA, you'll have to compute the income tax on the portion of the account assets converted. Ordinarily, the entire amount converted becomes taxable income, but if you've made nondeductible contributions to any IRA, the percentage of your total IRA assets composed of investment earnings and tax-deductible contributions is determined and applied to the converted assets. When the employer plan assets are converted, the taxable portion of the conversion is determined separately from all IRA assets and from any other employer plans.
There are a number of factors to consider before converting to a Roth IRA. If you have a long investing time frame, you may have enough time to benefit and recoup the tax hit if you decide to pay the taxes with money from your account. However, if you are close to retirement, a conversion generally may make sense if you can pay the tax out of other savings, rather than tapping into the assets in the account you want to convert.
Another option to consider when your goal is to pass assets on to your heirs is a "dividends and interest only" strategy for spending down assets in retirement. In this case, you would invest in interest-paying bonds and dividend-paying stocks with your IRA. In some cases, the interest and dividends generated within the account may be enough to cover your MRDs, and allow you to preserve most, if not all, of the principal in your account. This method does not guarantee that you will comply with the IRS MRD rules.
4. Do you want to make charitable donations now?
The strategy involves performing a Roth IRA conversion, then making a charitable contribution out of a taxable account in the same amount as the conversion. In general, the goal is for your donation to help reduce your taxable income by the same amount that the conversion increases it, leaving you with little or no tax impact.
For example, say you plan to convert a traditional IRA to a Roth IRA and $100,000 of the assets in the account will be taxed. Making a deductible charitable donation from a taxable account worth $100,000 would offset the converted assets, leaving you with no additional liability.
The upshot? Your account would be converted to a Roth IRA—eliminating future MRDs and providing tax-free potential growth1—at little or no cost and you'd advance your philanthropic objectives. Note: There are IRS limits to deductible charitable donations. Generally the limit is 50% of AGI if cash is used and 30% if appreciated securities are used.
"This move is driven by the desire to convert to a Roth IRA," cautions Hevert. "If you don't have a need for a conversion, you may be better off not converting and simply making a charitable donation."
Generally, anyone who is over age 75 and has large charitable intentions should skip a Roth conversion, unless he or she is in extremely good health. Typically, the most tax-efficient asset to leave to charity at death is a traditional IRA because the charity does not pay income tax, and the charitable bequest is excluded from an investor's taxable estate. While there may be exceptions to this general rule, the majority of older taxpayers with substantial charitable intentions will fall under this rule.
Whichever scenario applies to you, MRDs are likely to play an important role in your finances in retirement. Building a thoughtful retirement income plan can help you use MRDs in the most effective ways and help you reach your important financial goals. At the very least, it's important to spend some time understanding MRDs and your options to help avoid a costly mistake.
Before investing, consider the fund's investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully.
1. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, become disabled, make a qualified first-time home purchase, or die.
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