Distributions from traditional IRA retirement accounts is something that most taxpayers who used these accounts will encounter one day. There are several very important items to remember when taking distributions from traditional IRA accounts in order to avoid tax surprises.
Tax on Distributions from Traditional IRA Retirement Accounts
Although advance planning is needed to help accumulate the biggest possible retirement savings in an IRA, it is essential to plan for distributions from these tax-deferred retirement planning vehicles. There are three areas where knowing the ins and outs of the IRA distribution rules can make a big difference in how much you and your family will keep after taxes.
Taking Early Distributions from a Traditional IRA
Early distributions from traditional IRA. If you need to take money out of a traditional IRA before age 59-1/2, any distribution to you will be fully taxable at your ordinary income tax rate (unless nondeductible contributions were made, in which case part of each payout will be tax-free). In addition, distributions before age 59-1/2 may be subject to a 10% penalty tax. You can avoid this penalty tax by proving conditions such as hardship or that the IRA contribution was required to pay for education expenses. Although there are way to avoid the penalty tax, there is no way to avoid the ordinary income tax. This makes sense because the money was put into the IRA pretax and will need to be taxed when it is taken out of the traditional IRA account. This would be very different if it were a Roth IRA account.
Naming IRA Beneficiaries
Naming beneficiaries. Who you designate as a beneficiary of your IRA is very important because it ultimately decides where the IRA will end up after the death of the original IRA owner. This decision affects the minimum amounts you must withdraw from the IRA when you reach age 70-1/2, who will get what remains in the account at your death, and how that IRA balance can be paid out. It is essential to change the beneficiary of an IRA to reflect changes in a taxpayers overall estate plan. It is often hard to change who will receive an IRA via will and this must be done with the IRA account provider instead. Confusion in these area could lead to significant hassles after the original IRA owner dies.
Taking Required Distributions (RMDs) from Traditional IRA
Required distributions from Traditional IRA. Once you attain age 70-1/2, distributions from your traditional IRAs must begin. If you don’t withdraw the minimum amount each year, you may have to pay a 50% penalty tax on what should have been paid out, but was not. This penalty is severe, however, it is possible to ask the IRS for leeway if you forget to take a RMD in a particular year. In planning for these required distributions, your income needs must be weighed against the desirable goal of keeping the tax shelter of the IRA going for as long as possible for both yourself and your beneficiaries. This means that traditional IRAs should be coordinated with other retirement assets.
IRA Minimum Distribution Rules (RMDs)
Minimum distribution rules are imposed to prevent participants from unreasonably deferring the tax on their retirement savings. Under these rules, distributions are required to begin, for a participant other than a 5-percent owner, no later than April 1 of the calendar year following the later of:
- the calendar year in which the participant reaches age 70 1/2, or
- the calendar year in which the participant retires.
The minimum distribution rules do not apply to Roth IRAs while the account owner is alive, but do apply to traditional IRAs, deferred compensation plans, tax sheltered annuities, and qualified retirement plans