As traditional retirement plans seem to have gone the way of the dodo, U.S. workers are keeping their savings in their own retirement accounts. A growing number of Americans are choosing to grow their nest egg through an Individual Retirement Account (IRA).
Since their inception in 1974, Americans have put trillions of dollars into these tax-advantaged accounts, both through direct contributions and rollovers from employer-sponsored plans. Employee Benefit Research Institute estimates there are about 25.8 million IRAs with up to $2 in assets. 46 trillion in assets today in the U.S.
It's no wonder IRAs are so popular with Americans. Not only are contributions to a traditional IRA generally tax-deductible, but the earnings in the account grow back tax-deferred. In other words, if you have a traditional IRA, you won't be taxed on assets in the account until you withdraw them. This allows you to defer tax payments until retirement, when you will most likely fall into a lower tax bracket.
To top it off, anyone younger than age 70 ½ can contribute to a traditional IRA with some form of earned income – whether he or she is employed by a business, self-employed or a non-employed spouse contributing earned income from his or her spouse's check.
But how exactly does a traditional IRA work after retirement? What happens when it's time to use those tax-restricted IRA earnings?
Win, lose or withdraw
Technically, you can withdraw money from an IRA at any time. However, if you decide to take funds from your IRA before you hit age 59 ½, you will likely have to withdraw a 10% early withdrawal penalty, in addition to paying income taxes. The taxes and penalties you pay depend on your age at the time of distribution and the tax deductibility of contributions (depending on whether you are also covered by an employer-sponsored retirement plan).
Note that the IRS will waive this penalty if the distributions are used for certain purposes, such as z. B. Unreimbursed medical expenses, health insurance, qualified higher education expenses or to purchase a first home. (For more information, see 9 Penalty-Free IRA Withdrawals .) Also, you can take a no-fee loan from your IRA if you replace the money within 60 days.
"A little-known strategy for accessing IRA funds without penalty before age 59½ is the 'reverse rollover,'" says James B. Twining, founder of Financial Plan, Inc. In Bellingham, Wash. Individuals age 55 or older who have a 401 (k) that accepts rollovers and allows early retirement withdrawals at age 55.Using this technique, IRA funds are first rolled into the 401(k), then the 401(k) funds are withdrawn without penalty. "
Once you reach the magic age of 59½, you can start taking IRA penalty distributions – although they are still subject to income taxes, of course. However, you don't have to start taking distributions when you reach 59½ or when you retire. In fact, you can defer distributions for more than a decade after that milestone half birthday.
Required distributions
The next half-birthday IRA milestone is 70½, after which must begin to take required minimum distributions (RMDs) from traditional IRA accounts. At that time, you can either withdraw the full balance of the IRA, simply withdraw the minimum amount each year-or take out a number in between.
You must make your first required minimum distribution by 1. April of the year after you turn 70 ½ years old, assume. If you turn 70½ in August 2017, you'll need to make your first RMD by 1. April 2018 take. If you choose to take a minimum distribution, you must do so by 31. December of each year do. If you choose to withdraw your first RMD by 1. April of the year following your move to defer by 70½ months, you must take a second RMD amount in the same year, which is considered the second year for RMDs.
Seems like a lot to remember, doesn't it? No worries. Generally, the IRA custodian or financial institution will calculate your RMD amount and notify you of upcoming distribution deadlines. And, "If you have multiple IRA accounts and one is performing poorly, you can draw the [full] RMD from the worst-performing IRA to satisfy the RMDs on all of them," says Carlos Dias Jr., Founder of Excel Tax & Wealth Group in Lake Mary, Fla.
What happens if you don't take the required IRA distributions after your 70 ½ birthday? "If you don't take an RMD on time, there can be serious consequences," says Christopher Gething, founder of Atherean Wealth Management, Jersey City, NJ. "Unless you can convince the IRS that the distribution was not adopted. You will be subject to a penalty tax of 50% of the missed distribution. "
Retreat strategies
Although you have to start taking distributions from your IRA at age 70 ½, that doesn't mean you have to spend the money. Determine how best to allocate these funds based on your overall retirement income plan. If you don't necessarily need the money for living expenses, you can choose to put those IRA distributions back to work.
For example, you might consider purchasing an annuity to convert your assets into a stream of income payments guaranteed for life. (There are some restrictions on the types of annuities you can fund with RMDs, so check with a tax professional before choosing one.) Or you could choose to invest the distributions from your IRA in municipal bonds, stocks, mutual funds or traded funds (ETFs).
Another alternative: converting your traditional IRA assets to a Roth IRA.If you do this, you no longer have to worry about RMDs and your distributions are not taxable. This is of particular interest to IRA holders who want to leave a legacy. Since a Roth IRA has no RMDs during your lifetime, you can leave the assets in place, allow them to grow tax-free, and bequeath the account itself to your survivors. However, in the year you use this strategy, you will likely incur a large tax liability. (For more information, see Converting Traditional IRA Savings to a Roth IRA .)
The last line
When it comes to traditional IRAs, there are many complicated distribution and tax rules that must be followed. Mind. It can be difficult to determine when and how much to withdraw and how to reinvest distributions if you don't spend them. Start planning well before the 70½ year milestone. Considering all the regulatory requirements, you don't want to make any sudden moves with your IRA.