11/02/99

Demystifying the IRA

One of the most complex arenas of financial planning is the IRA. At this point you may think I am joking, but I am not. The interesting, complex and potentially rewarding aspect of the IRA is not in the contribution phase -- adding up to $2,000 per year, but in the withdrawal and distribution phase; and even more so at the death of the participant. In this article I will explain the basic rules governing withdrawals- before age 59 1/2 and those governing mandatory distributions when you come of age. In later articles, I will discuss the complexities of the IRA at the participants death, nonspouse beneficiary rules and the advantages of an extended generation IRA

Distributions Before Age 59 1/2

Most everyone knows of the advantages of tax deferred growth in IRA accounts, but when it comes time to get money out, the various rules are not always fully understood.

As you may know, the IRS has chosen age 59 1/2 as the age after which one can withdraw money from their IRA for any reason without a 10% penalty. However, there are ways to get money out of your IRA before age 59 1/2 and avoid the penalty!

Rule 72T

One of the most advantageous options for IRA distributions is IRS rule 72T -- substantial equal periodic payments. This is perhaps one of the least known and used rules. However, if you are trying to retire before age 59 1/2 and you want or need to draw on the money you have accumulated in retirement accounts (without a 10% penalty) this option could allow you to retire early. Under this rule, you can avoid the penalty by taking withdrawals in substantially equal payments for your life expectancy (or joint with owner and beneficiary) at least annually. No changes can be made to this selection until the participant is 59 1/2 or for 5 years whichever is greater.

Other Withdrawal Options

There are a host of other ways to redeem money from an IRA account and avoid the penalty pre 59 1/2. Distributions and withdrawals avoid the 10% penalty if they are:

• Used to pay qualified higher education expenses for the participant, spouse, child or grandchild.

• Due to the participants death or disability.

• For medical expenses in excess of 7.5% of AGI.

• Made by an unemployed individual to pay for health insurance premiums, in certain situations

• For the purchase of a home for a first time home-buyer up to $10,000.

• Paid to you but you place it in an IRA account within 60 days.

Clearly, the above exemptions make the IRA a good tax deferred tool for someone saving for a first house and/or for families saving for higher educational costs, thereby expanding the use of the IRA beyond just a retirement planning tool.

These exemptions also exist for the Roth IRA, but only after the account has been open for 5 years or more.

Penalty Free not Tax Free -- while the above options enable you to avoid the 10% penalty on withdrawals before age 59 1/2 you still must pay taxes (at current income tax rates) on them. So remember to budget in the tax consequences if you need to withdraw money "early'.

After Age "70 1/2"

You have worked hard all your life and you have saved diligently towards retirement. However, at a certain age, Uncle Sam requires that you take a minimum annual distribution from your retirement accounts. Why you ask? -- because most money in these accounts have never been taxed and the government is using the mandatory distributions to get this money into the tax stream.

Specifically, you must take a required minimum distribution out of your IRA by April 1st of the year after the year you turn 70 /12. This date is called the required beginning date. Thereafter, the minimum distribution must be made by the end of each calendar year. However, the amount of the required distribution will vary with how you choose to take it. (If the IRA holder fails to take this distribution, a 50% excess accumulation penalty applies on the amount that should have been taken.)

Please note that there is no required minimum distribution for Roth IRAs. Investments in Roth IRAs can continue to grow tax free -- which is one of the advantages of the Roth.

Calculating Required Minimum Distributions

The required distribution is based on the value of the account as of the end of the prior year (Dec. 31) divided by the "appropriate" life expectancy. You have a choice over how life expectancy is determined and whether or not it is recalculated every year after the first year. First, you can choose to have life expectancy based on the single life expectancy of the IRA holder or the joint life expectancy of the IRA holder and the oldest primary beneficiary. Second, you can choose to have the distribution recalculated or not recalculated, if the primary beneficiary is a spouse, in the years following the initial distribution. If you choose nonrecalculation, your distribution will be based on the initial life expectancy figures used in year one (joint or single) and simply reduced by one each subsequent year. If you choose recalculation new life expectancy figures are used each year based on the new age(s).

What does all this mean? Essentially it means if you or your parents are at this age you have some decisions to make. Furthermore, if you do not need more than the absolute minimum from your IRA, you should choose wisely. The less you take from the IRA, the more money will be left to grow tax deferred. Choosing joint life expectancy and the recalculation method enable you to withdraw the absolute minimum each year.

(IRA holders who have chosen nonspouse beneficiaries who are more than 10 years younger than the IRA holder must follow the Minimum Distribution Incidental Benefit (MDIB) Rule.)

Please remember that these rules are for required minimums only. You can always take out more money than the required minimum as desired or necessary.

Please send questions or comments to dcoffin46333@wradvisors.com.