By PAUL KATZEFF, INVESTOR’S BUSINESS DAY
We had $5.7 trillion tucked away in IRAs as of the end of the second quarter, according to the Investment Company Institute. That dwarfed the $3.8 trillion at work in 401(k) plans.
But harsh tax rules mean that a false step with your IRA can be costly. So here are six tips for making the most of your IRA, both for yourself and your heirs.
• Beneficiary. Many people think of their will as the document with the last say when it comes to their estate. That’s not true for your IRA.
For that account, your beneficiary is the person you name in your IRA custodian’s designation form. It does not matter who, if anyone, you name in your will. A community property state may require you to designate your spouse, says IRA Advisor editor Ed Slott.
So, if you want to name a beneficiary, use that form. If you want to change your beneficiary, file an amended designation form with your financial firm.
• RMDs. With a traditional IRA, the owner must start required minimum distributions (RMDs) by April 1 of the year after he or she turns 70-1/2. RMDs are based on IRS life expectancy tables. You calculate each year’s RMD by dividing the balance as of the prior Dec. 31 by your life expectancy in the IRS table that applies to you.
• Roth IRA. You can avoid having to take RMDs by using a Roth IRA instead of a traditional one, or by converting a traditional IRA to a Roth. With a Roth, no RMDs are required. You can convert a traditional IRA to a Roth. You’ll owe income tax on the amount converted, but your eventual withdrawals, if any, will be tax free. That can leave more for your heirs to inherit tax free.
• Rules for heirs. Heirs do not have as good a deal as an original account owner does. After getting the account tax-free, nonspousal heirs must start withdrawals, based on an age-based formula, by Dec. 31 of the year after they inherit the IRA. That’s the case whether it’s a traditional or Roth IRA.
Younger beneficiaries can take smaller withdrawals, allowing the account balance to keep growing tax-deferred longer.
Some heirs mistakenly think they don’t need to take RMDs from an inherited Roth. They do. But there’s no tax. “But if they don’t make the withdrawal, they’re subject to a 50% penalty — far worse than any tax would have been,” Slott said.
Spouses. Spousal heirs can keep an inherited IRA as an inherited IRA or roll it into his or her own name. The terminology matters.
If a spousal heir takes an inherited IRA (traditional or Roth) as a beneficiary, then RMDs must start in the year his or her deceased spouse would have turned 70-1/2. But if she takes a traditional IRA as a rollover, it is treated as if it had always been hers. If she is young, it may be years or even decades before RMDs must start. If it’s a Roth, RMDs never start.
Still, a spousal heir younger than 59-1/2 should take it as an inherited IRA in case she needs the money. That way she can dip into the account without paying a 10% penalty for early withdrawal, Slott says.
• Estates. Never name your estate as a beneficiary unless you have no beneficiaries or don’t care about their tax burden, Slott says.
RMDs for an estate follow different rules. In many cases the withdrawals must be within a short number of years, resulting in quick depletion of the original account.