Taking Money Out of Your IRA

Here are some general rules on how funds coming out of IRA accounts are treated for income tax purposes.

Taking Money Out of Your IRA

Most of us think of IRAs and retirement plans as financial tools for asset accumulation. We often pay little attention to how funds can be withdrawn from the accounts until retirement. Here are some general rules on how funds coming out of IRA accounts are treated for income tax purposes. This discussion applies only to regular IRAs since "Roth IRAs" are treated very differently. You may want to consult your tax advisor for more details or to determine how specific rules would apply to you.

Distributions before age 59½

The general rule is that funds withdrawn from an IRA qualified plan before age 59½ are subject to an additional tax of 10% on top of being reported as taxable income in the year taken. However, there is a special rule that can be applied for distributions taken using a life expectancy formula that will also avoid the penalty. There are a few exceptions for death and disability.

Distributions from age 59½ to age 73

Once you reach age 59½, you can then start withdrawing funds without penalty. You can withdraw any amount from zero to the entire amount in the IRA. Withdrawals you take are subject to income taxes. If you are still working or do not need the funds, you will probably leave them in the account and continue to earn tax-deferred returns as long as possible.

Distributions after age 73

After you reach age 73, you must start taking distributions from your plan. This forced distribution concept was established to eliminate the possibility of someone accumulating huge amounts of money that continued to grow tax deferred. The IRS has also established rules to force you to take a minimum amount each year. This is called the Required Minimum Distribution (RMD).  There is a more detailed discussion of RMDs below. You can also take more than the minimum. Withdrawals you take are subject to income taxes.

Distributions at death

The beneficiary designated as part of your IRA will determine whom the funds in your IRA pass to when you die. This transfer is not governed by your will. If you designate your estate as the beneficiary, funds would then be available to be distributed according to your will. This is also the case if you have no designated beneficiary. That distribution triggers the income taxation of the funds in the IRA.

If you designate your spouse as the beneficiary, the IRA passes “intact” and the IRS will treat it as though it has been his or hers all along, subject to the normal distribution requirements (pre-59½, 59½ to 73 and after 73).

For non-spouse beneficiaries, the beneficiaries have to set up an inherited IRA account and transfer the funds into the new account. Non-spouse beneficiaries must then distribute all the funds within 10 years, paying ordinary income taxes on withdrawals. For minor children, they must start distributions immediately, but the withdrawal rate is based on their life expectancy. Once they turn 18, they have 10 years to withdraw the entire account.

Another exception to the 10-year rule is if the beneficiary is less than 10 years younger than the deceased IRA owner. For them, the normal distribution requirements apply.

Required Minimum Distributions

At age 73, the IRS forces you to start taking withdrawals.  The amount that must be withdrawn is based on the life expectancy tables provided by the IRS. The rules for determining how much you must take were simplified in early 2001. A uniform new life expectancy table was adopted and generally provide for smaller RMDs.

If you are currently required to take RMDs, you should consult your tax advisor to determine how the new rules apply and whether you should make changes in your distribution levels. These new rules took effect in 2002.

Summary

Individual Retirement Accounts can be the foundation of a successful plan for a financially secure retirement. Tax deferral on the earnings and the new beneficial rules for required minimum distributions make these accounts even more attractive. Some of the rules are complex, especially concerning distributions, and a thorough discussion with your tax advisor can help you understand your options.