Withdrawals from Individual Retirement Accounts (IRAs)

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1 October 2006 FR/Financial Fitness/ Withdrawals from Individual Retirement Accounts (IRAs) Barbara R. Rowe, Ph.D. Professor and Family Resource Management Extension Specialist Utah State University Individual retirement accounts (IRAs) have been available to all wage earners since 1982, when they were created by Congress to encourage Americans to save for retirement. They are available if you have income from working, or are the spouse of a worker, even if you have another retirement plan. IRAs are sold by banks, credit unions, mutual funds, savings and loan associations, insurance companies and brokerage firms. Since 2001, there have been many changes in the regulations governing withdrawals from IRAs. Deadlines have been eliminated, a simplified distribution table has been created and inheritance rules have been simplified. This fact sheet explains the new rules. Traditional IRAs A person under the age of 50, who has income from working can contribute up to 100% of a year s earnings, or $4,000 a year ($5,000 in 2008), whichever amount is less, to a traditional IRA. This amount is reduced by the amount of any contributions to a Roth IRA (see below). Starting in 2006, if you are over age 50, you can contribute an additional $1,000 a year. Your adjusted gross income (AGI), your tax filing status and whether you participate in a qualified retirement plan determine if your contributions are 100% deductible from federal, state and local taxes until the money is withdrawn. If either you or your spouse are an active participant in an employer retirement plan or selfemployed retirement plan for any part of the year all of your IRA contributions may not be tax deductible. For single filers who also participate in an employer s retirement plan, the amount you can deduct in begins to phase out once your income is $50,000 until it reaches zero at $60,000. If you file as married filing jointly, and you or your spouse are covered by a retirement plan at work, the tax deduction begins to phase out at $75,000 in In 2007, the deductibility phase-out limits increase to $80,000-$100,000. Spousal IRAs If a spouse has no income from working, a spousal IRA may be opened with an annual limit of $4,000 in taxable contributions even if the working spouse participates in an employer s retirement plan. The deduction is phased out at adjusted gross incomes between $150,000 and $160,000. In 2008, you can contribute the lesser of your earnings or $5,000 to a spousal IRA. If your spouse is 50 years old or older, you can contribute an additional $1,000 for the years

2 Roth IRAs Introduced in 1997, Roths were named after Senator William Roth, who vigorously supported their establishment. Contributions to a Roth are made with after-tax dollars. However, all withdrawals, including accumulated earnings on contributions, are tax-free, provided the owner is age 59 ½ or older and has owned the account for five years. Congress designed Roths to be much like a traditional IRA with some important exceptions. They are only available to singles with incomes up to $95,000 and married couples with incomes between $150,000 and $160,000. Contributions are limited to $4,000 a year with a $1,000 catch-up provision for individuals age 50 or older for the years These amounts increase to $5,000 and $1,000 in With a traditional IRA, no contributions are permitted after age 70 ½. However, you may make contributions to a Roth after age 70 ½ as long as you have earned income and your adjusted gross income doesn t exceed the limits described above. Withdrawals from a traditional IRA prior to the owner turning age 59 ½ are subject to a 10% excise tax unless they fall under one of the exceptions noted below. However, early withdrawals from a Roth IRA can be made for college expenses, qualified un-reimbursed medical expenses, payment of health insurance premiums by an unemployed person, and qualified first-time home buyer expenses (up to a lifetime maximum of $10,000) as long as the account has been in existence for five or more years. If you have a traditional IRA, you must begin required minimum distributions (RMD) on or before your required beginning date (RBD), usually April 1 st following the year in which you reach age 70 ½. If you have a Roth IRA, you are not required to withdraw any amount during your lifetime. Rollovers from a Traditional to a Roth IRA Traditional IRAs may be converted to Roth IRAs if your modified adjusted gross income is less than $100,000 (not including the rollover amount). However, to do so, you will have to pay income taxes on the earnings plus deductible contributions of the amount rolled over. So the traditional IRA owner must decide whether it is better to pay some income taxes now and be able to withdraw future earnings tax-free during retirement (assuming the Roth is held at least five years and the owner is age 59 ½ or older) or leave the money in the traditional IRA where it will continue to grow tax-deferred until withdrawal. You can make partial conversions each year for several years to spread out the tax burden. If married, you must file jointly to roll over your IRA, and a rollover Roth IRA must be kept as a separate IRA. Generally, the longer the period until you start taking the money out of the traditional IRA and the higher the expected rate of return, the more advantageous it may be to roll over money from a traditional IRA into a Roth. But if you are nearing retirement, it may not be worthwhile. Also, the larger the amount being rolled over, the more cash is needed to pay the income taxes due. Withdrawals before Age 59 ½ Because Congress intended IRAs to be a retirement savings vehicle, there is a 10% excise tax on any withdrawal when the owner is under age 59 ½ unless he or she falls under the following exceptions. Remember, if you qualify under an exception, only the 10% excise tax is excused. The money withdrawn is still reported as income on your tax return and you must pay income taxes on it. The first exception is death; none of the funds distributed from your IRA after you die will be subject to the early distribution tax as long as the account is still in your name when the distribution occurs. If you become disabled, you can take money out of your IRA without worrying about the early distribution penalty. If you begin taking distributions from your IRA in substantially equal annual installments and those payments are designed to be spread out over your entire life or the joint life of you and your beneficiary, then the payments will not be subject to the 10% early distribution tax. If you withdraw money from your IRA to pay medical expenses for yourself, your spouse or your dependents, no early distribution tax will be assessed to the extent they exceed 7.5% of your adjusted gross income. Distributions you use to pay higher education expenses will not be subject to the early distribution tax as long as they are paid on behalf of you, your spouse, child or grandchild. You may make an early withdrawal to buy or build your first home (up to a lifetime maximum of $10,000) and for health insurance premiums for 2

3 yourself or your dependents if you are unemployed or were recently unemployed. Withdrawals between age 59 ½ and 70 ½ The ages 59 ½ and 70 ½ are the penalty free zone. The owner of a traditional or Roth IRA can choose to withdraw the entire balance in the account or any amount as needed without paying the 10% early distribution tax. However, withdrawals from a traditional IRA are added to the owner s income for the year and are subject to state and federal income taxes. If the owner is receiving Social Security, the withdrawal may cause part of the individual s Social Security benefits to be taxed as well. Most people will use the Uniform Lifetime Table (see Table 1) to determine the number of years over which they may spread distributions. However, if your spouse is the beneficiary of your IRA and is more than ten years younger than you, you will use a different table, called the Joint Life and Last Survivor Table (see Table 2). Withdrawals after Age 70 ½ Owners of a traditional IRA must begin taking required minimum distributions (RMD) from their accounts by April 1 following the year in which they reach the age of 70 ½. (Roth IRAs do not have a mandated start date for distributions.) For each subsequent year, the deadline is December 31. Failure to withdraw your required minimum distribution (RMD) can result in a penalty equal to 50 percent of the difference between your RMD and the amount you actually withdraw. Although you are permitted to take the required distribution in one lump sum, you don t have to. You can take it out as you need it, for example in monthly or quarterly installments, as long as the minimum amount is removed from your account annually. Remember, amounts distributed before January 1 of the year you turn 70 ½ do not count toward your first required distribution, nor do amounts distributed after your RBD (required beginning date). You must take the minimum distribution between January 1 of the year you turn 70 ½ and April 1 of the year after you turn 70 ½, which gives you 15 months to make your first withdrawal. Table 1. Uniform Lifetime Table Age of IRA Owner Life Expectancy in Years Age of IRA Owner Life Expectancy in Years and older 1.9 Calculation of Required Minimum Distributions (RMDs) During Life of IRA Owner after Age 70 ½ Calculating your required distribution for any given year is just a matter of determining an account balance for your IRA and dividing that balance by the appropriate life expectancy, or what IRS calls the applicable distribution period (ADP). According to the tax code, the account balance for computing your required distribution each year is determined on December 31 of the year before the distribution year. To find your ADP for your first distribution year, you must use one of two tables (see Tables 1 and 2). 3

4 Table 2. Joint Life and Last Survivor Table Owner s Beneficiaries Age Age Most people will use what the IRS calls the Uniform Lifetime Table, but some people will be able to use the Joint Life and Last Survivor Table. The table you use depends upon the age of the person you choose as your beneficiary. If your spouse is the sole beneficiary of your IRA and is more than ten years younger than you are, you may not use the Uniform Lifetime Table. Instead you will use the Joint Life and Last Survivor Table (Table 2). To determine your Applicable Distribution Period on the Last Survivor Table, look up the number that corresponds to your age and your spouse s age on your respective birthdays in your first distribution year. For example, if you are age 70 on your birthday in your first distribution year (the year you turn 70 ½) and your spouse is age 55 in that year, your ADP from the Last Survivor Table is If your beneficiary is a child, grandchild, or friend who is not more than ten years younger than you are, you will use the Uniform Lifetime Table. If you haven t yet named a beneficiary by your first distribution, you will still use the Uniform Lifetime Table. To find the ADP for your first distribution year, you determine your age as of your birthday in the year you turn 70 ½. If that age is 70, then find the ADP next to age 70 in the Uniform Lifetime Table (Table 1). That number is If your age is 71 on your birthday in the year you turn 70 ½, the ADP from the table is For example, your birthday is in August. You turn 70 ½ in February. Then when your birthday comes in August, you d be 71 and would have to use 26.5 as your ADP instead of Determining the ADP for the second and future distribution years is done in precisely the same way you determined the ADP for the first year. Once you have determined the appropriate account balance and distribution period, you simply divide the account balance by the ADP to arrive at your required minimum distribution. You are always free to withdraw more than your RMD, but you may not withdraw less without incurring a penalty. It is up to you to compute the correct required distribution and report it on your tax return. Designated Beneficiary The designated beneficiary of your IRA must be a natural person, as opposed to a charity or a corporation. There is one exception to this rule a trust that has certain qualifications (known as a qualified trust) can be a designated beneficiary. Even if you do not have a designated beneficiary, your plan may provide for a default beneficiary, usually a spouse. Be sure to find out if your plan has such a default provision. You may name several primary beneficiaries of your IRA who may or may not share equally in the income after your death. If any one of the primary beneficiaries fails to qualify as a designated beneficiary, you are deemed not to have a designated beneficiary. This is true even if all other beneficiaries would qualify. 4

5 What if You Die Before Age 70 ½? The IRS says you must start taking money out of your IRA by your required beginning date (April 1 of the year after you turn 70 ½). But what if you don t make it to that date? The rules for distribution vary depending on who you name as your beneficiary. Your retirement plan could be distributed using one of three methods: (1) the life expectancy rule, (2) the five-year rule, (3) or a spousal rollover. The life expectancy rule allows your beneficiary to spread distributions over his or her life expectancy if your beneficiary is a designated beneficiary, and the plan permits the life expectancy rule. The five-year rule is mandatory where you die before your RBD, and your IRA is deemed to have no designated beneficiary as of September 30 of the year after your death. This rule is designed to assure that the total amount in your IRA is completely distributed within five years of your death and the taxes you have been deferring are collected. Now if your beneficiary is your spouse, he or she can leave the account in your name and use the life expectancy rule to take distributions for his or her own life expectancy beginning in the year after you would have been 70 ½ or he or she may roll the plan over into an IRA in his or her own name. Withdrawals from a Roth IRA Congress designed the Roth IRA to be much like a traditional IRA, but with some attractive adjustments. All contributions to a Roth are made with after-tax dollars. Therefore all distributions are potentially tax free, including any earnings realized on the account. However, Roth contributions are limited to earners with adjusted gross incomes under $160,000 if married and $110,000 if single. And, unlike a traditional IRA, you may continue to make contributions to a Roth after age 70 ½ (as long as you have earned income and your income doesn t exceed the limits described above). Also, if you have a Roth IRA, you are not required to withdraw any amount during your lifetime. You may leave the entire account to your beneficiaries. The portion of your Roth IRA that contains your contributions is never subject to income tax when it comes out. You have already paid tax on the money. Further, any distribution you take from a Roth is presumed to be a return on your contributions. And they are not taxable as long as the distribution is considered a qualified distribution. Any distribution of returns on a Roth taken within five calendar years of when you established the account can never be a qualified distribution. If you die before the five years are up, your beneficiary must wait until the five-year holding period has elapsed or the distribution will not be qualified. To be qualified (i.e., tax-free), a distribution must also be one of the following: Taken after you reach 59 ½ Taken after you become disabled Distributed to your beneficiary or your estate after your death Taken to purchase a first home (up to $10,000) Any withdrawals from a Roth that are not qualified are treated much like a traditional IRA distribution. The contributions you made will come out tax-free, but the earnings are taxable. If you have a traditional IRA, you must begin required distributions when you reach your RBD (required beginning date). But because you are not required to take distributions from a Roth during your lifetime, you have no RBD for that purpose. Consequently, it is relevant whether you die before or after your RBD (or the date that would have been your RBD for traditional IRA purposes). Instead, the life expectancy rule or the five-year rule (see above) will apply to your Roth IRA regardless of when you die. Summary The rules for withdrawing funds from a traditional IRA or Roth IRA have been simplified to give you and your heirs more flexibility. People who withdraw funds before 59 ½ may still have a 10% early distribution tax levied on the withdrawal unless the distribution falls within one of the special exception rules. And failure to withdraw the required minimum distribution starting the year after reaching age 70 ½ may result in a penalty equal to 50% of the undistributed amount for traditional IRA owners. However, changes in contribution amounts and a Uniform Lifetime Table will help most owners minimize taxes, avoid 5

6 penalties and make sense of these important retirement plans. References Block, J. Are IRAs tax deductible? Retrieved July 20, 2006, from Goetting, M.A., and Juras, K.G Withdrawals from IRAs when owner is between 59 ½ and 70 ½ and when owner turns 70 ½. (Montguide HR). Bozeman, MT: Montana State University. Tax Policy Group Seeds of change: The 2001 tax cut. Washington, DC: Deloitte and Touche, LLP. Slesnick, W., and Suttle, J.C IRAs. 401(k)s and other retirement plans: Taking your money out. Berkeley, CA: Nolo Press. Utah State University is committed to providing an environment free from harassment and other forms of illegal discrimination based on race, color, religion, sex, national origin, age (40 and older), disability, and veteran s status. USU s policy also prohibits discrimination on the basis of sexual orientation in employment and academic related practices and decisions. Utah State University employees and students cannot, because of race, color, religion, sex, national origin, age, disability, or veteran s status, refuse to hire; discharge; promote; demote; terminate; discriminate in compensation; or discriminate regarding terms, privileges, or conditions of employment, against any person otherwise qualified. Employees and students also cannot discriminate in the classroom, residence halls, or in on/off campus, USU-sponsored events and activities. This publication is issued in furtherance of Cooperative Extension work. Acts of May 8 and June 30, 1914, in cooperation with the U.S. Department of Agriculture, Noelle Cockett, Vice President for Extension and Agriculture, Utah State University. 6