Your Retirement Benefits

The stock market growth of the past few years has added tremendous value to the retirement plans of many Americans and made it much easier for them to maintain their standard of living once they stop working. However, it has made one of the more difficult financial and legal planning decisions facing most Americans that much more important. Not only are the mandatory withdrawal rules complicated, but it's impossible to predict how long you're going to live. Choices you make today, in retrospect, may appear brilliant or badly mistaken, depending on your lifespan and that of your spouse.

Following are the basic rules governing taking minimum distributions from retirement plans and a few pointers for getting the most out of them.

Calculating Your Minimum Distribution

Congress created the rules described below to encourage saving for retirement. They imposed a penalty for early withdrawal and a penalty for failure to withdraw once the owner reaches retirement age.

These penalties are in the form of excise taxes. Withdrawals (with limited exceptions) before age 59 ½ are subject to a 10 percent excise tax. The plan participant must begin taking distributions by the April 1 occurring after he or she reaches age 70 ½ (known as the required beginning date), or pay a whopping 50 percent excise tax on the amount that should have been distributed but was not.

In general, the advantage of retirement plans is that the participant may save income before taxes during his or her working career and continue to have such savings grow without paying taxes until the funds are withdrawn. This permits the retirement savings to grow at a much faster rate than other savings and investments. The participant must pay taxes on any amounts withdrawn. As a result, it usually makes sense to postpone withdrawals for as long as possible.

The amount the participant must withdraw after reaching age 70 ½ is based on her own life expectancy and that of the person she names to receive the plan after her death, known as the designated beneficiary. At the required beginning date, your life expectancy will be either 15.3 years or 16.0 years, depending on whether you have reached your 71st birthday before the applicable April 1st cutoff date. If you have not designated a beneficiary, you will have to withdraw 1/16th of your plan (assuming you're 70 years old on your required beginning date). In other words, if your plan holds $160,000, you'll have to withdraw $10,000 or pay a penalty.

On the other hand, if, for instance, you have named your spouse as your designated beneficiary and you are both 70 years old, your joint life expectancy will be 20.6 years, meaning that you can withdraw a smaller portion of your retirement plan each year, only $7,767 from a plan holding $160,000. In the first year alone, this would permit you to continue to invest an additional $2,233 tax free and save more than $700 in income taxes (depending on your tax rate). The savings can be even greater if you name someone younger than yourself as a designated beneficiary, but if you choose someone who is not your spouse, he or she will always be deemed to be no more than 10 years younger than you.

You can always change designated beneficiaries after you have reached the required beginning date, but they can never be used to reduce your minimum distributions. This means that if you have no designated beneficiary on your required beginning date, you will always be stuck making withdrawals based on your own life expectancy. So, the first rule of retirement plans is to always designate a beneficiary.

To Fix or Recalculate, That is the Question

The second consideration is not so straightforward. At your required beginning date, you may elect the "fixed" or "recalculation" method of determining your minimum distributions. As their names imply, under the first approach, the portions of your retirement plan that you must withdraw is based on your life expectancy and that of your designated beneficiary on the required beginning date. This never changes. Under the second approach, you withdraw a bit less than under the fixed approach each year because your life expectancy and that of your designated beneficiary are recalculated each year. The choice makes little difference during the first few years, but the longer you live the better off you are with the recalculation method. Under the fixed approach, when you and your spouse reach age 90 you will have withdrawn everything. But if one of you reaches that age your life expectancy will still be five years, meaning that you would only have to withdraw one fifth of what remained in your plan that year if you had opted for the recalculation method.

On the other hand, if you choose the recalculation method after one of you dies, you will have to base future distributions on the survivor's life expectancy alone. If one spouse dies at a young age, this choice could accelerate minimum distributions. So, what's the best approach? Some experts recommend always using the fixed methods. Others recommend always using the recalculation method unless you or your spouse has a shortened life expectancy for one reason or another. In short, there's no answer that's right for everyone. What you choose may depend on predictions of your longevity and that of your spouse based on your health and the lifespan of other family members. If you designate someone other than your spouse as your beneficiary, you may not elect the recalculation method with respect to their life expectancy, only for your own.

Post-Death Treatment of Retirement Plans

What happens to retirement plans after the participant dies depends on whether the decedent had named a designated beneficiary, whether that designated beneficiary is the decedent's spouse, and whether the participant died before or after her required beginning date. If the participant dies before his or her required beginning date and has not named a designated beneficiary, all of the plan must be distributed before the end of the fifth calendar year after his or her death. This is often referred to as the five-year rule. On the other hand, if the decedent had named a designated beneficiary, the assets may be distributed over the beneficiary's life expectancy. If the beneficiary is not the decedent's spouse, the distributions must begin by the end of the calendar year after the participant died. If the beneficiary is the surviving spouse, distributions must begin by the end of the calendar year in which he reaches age 70 ½ or the calendar year after the participant's death, whichever is later.

Again, these rules show the importance of designating a beneficiary. Without a designated beneficiary, the heir must take distributions of the entire plan within five years and pay income taxes on such distributions. With a designated beneficiary, the heir can take distributions over his life expectancy, which, for a 38-year-old child, for instance, would be 44.4 years. The ultimate difference to the heir may total hundreds of thousands of dollars over time, depending on the value of the retirement plan. You may designate more than one beneficiary, but the minimum distributions will be based on the life expectancy of your oldest beneficiary. Don't name a non-person, such as a charity, as a beneficiary of your plan or the five-year rule will apply to all of your beneficiaries.

If the plan participant dies after the required beginning date, again the outcome depends on whether he or she named a spouse as the designated beneficiary. If the participant did not designate a beneficiary, the heirs would be required to withdraw the entire plan within one year of the death of the participant.

The spouse has an option not available to other designated beneficiaries. They can roll the plan over into their own plan and it will be treated as if they had always been the owner. This means they can postpone withdrawals until the required beginning date and designate a new beneficiary.

A non-spouse designated beneficiary may withdraw from the plan based on their life expectancy and that of the decedent (unless the decedent elected the recalculation method, in which case the beneficiary must make withdrawals based on their life expectancy alone). Note, that in cases where the beneficiary is considerably younger than the decedent, this will allow smaller distributions than before the plan participant's death since the beneficiary will no longer be deemed to be only 10 years younger than the participant.

The Roth IRA

As if the rules described above were not complicated enough, as part of the Taxpayer Relief Act of 1997 Congress created two new planning vehicles: the Roth IRA, named after Senator William V. Roth (R-Del.) and the Education IRA. The Roth IRA, in effect, turns a traditional IRA on its head. While traditional IRAs permit the taxpayer to shelter pre-tax earnings but taxes them upon withdrawal, the Roth IRA is for after-tax savings, but both the original deposits and the earnings on them are not taxed on withdrawal. In addition, unlike traditional IRAs, Roth IRAs are available to taxpayers already contributing to a plan at work and to taxpayers who continue to work after age 70 ½. Finally, there is no minimum distribution requirement upon reaching that age.

Eligibility for the Roth IRA is limited to taxpayers with an adjusted gross income of under $114,000 if single and $166,000 if married. The contribution is limited to $5,000 a year, with smaller limits for taxpayers with income of between $99,000 and $114,000 if single and between $156,000 and $166,000 if married and filing a joint return.

Financial experts calculate that for many Americans a Roth IRA will save more money than a traditional IRA. This is because the future value of the interest earned, which will never be taxed, often far outweighs the value of deferring taxes on the investment itself. Consult with your financial advisor to help decide if a Roth IRA makes sense for you.

The Education Savings Account "ESA"

Similar to the Roth IRA, the Education Savings Account or "ESA" (formerly known as an education IRA) permits individuals to save up to $2,000 annually with the earnings accumulating tax free. This may be of special interest to parents and grandparents who can contribute this amount annually to accounts owned by their children and grandchildren. Although $2,000 a year isn't a lot of money given the size of college tuition, over time it can make a difference. It is only available to taxpayers whose adjusted gross income is under $95,000 for single taxpayers and $190,000 for married taxpayers filing a joint return, with limits on contributions for single taxpayers with income between up to $110,000 and between couples with income not exceeding $22,000. If the parents' income exceeds these levels, grandparents and others with lower taxable incomes can contribute to the accounts. But only $2,000 can be added per child per year.

Funds can only be added to the accounts while the child is under age 18 and must be withdrawn by the time he or she reaches age 30 or turned over into an account for another family member. An advantage with these accounts over most accounts created for children is that the funds do not have to be turned over to the child at age 18. But a word of caution: if you expect that your child or grandchild will apply for financial assistance for college, it may be wiser to invest the money in your own name. The financial aid application process for college has become increasingly complex, but, in general, colleges treat assets held by the family -- especially a grandparent -- differently from assets held by the student.

Only a portion of family assets are expected to be used for a specific student's education, while all of the child's assets are expected to be used before the student draws on financial aid.


While the rules regarding retirement plans are complicated (and the summary above only brushes the surface) the most important lesson is to always name a designated beneficiary and to make sure that you name individuals only. (You can also name a trust that meets certain requirements beyond the scope of this article.) The second lesson is to consult with a qualified professional advisor when you reach 70 ½, if not before.

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