Thursday, March 6, 2014

IRA Distribution Strategies

Individual Retirement Accounts (IRA) became popular with the Economic Recovery Tax Act of 1981. Some basic premises drove IRAs creation. (Other rules may apply):

  1. Some individuals could contribute money into an IRA account on a pre-tax basis, i.e. the money contributed into the IRA would not be taxable income at the time earned.
  2. Money in an IRA could be invested in a variety of investments commensurate with the individual’s risk preference. Income taxes would be deferred on those investment earnings until moneys were withdrawn from the account.
  3. Money withdrawn from the account would be subject to income tax at ordinary income tax rates.
  4. People who withdraw money from an IRA prior to age 59 ½ must pay ordinary income tax on the amount withdrawn plus a 10% premature distribution penalty.
  5. Required mandatory distributions from an IRA occur when the individual reaches age 70½. Tables from the Internal Revenue Service govern the amount of distribution.
  6. Contributions were generally limited to amounts from earned income and were traditionally in the low 4 digit range for maximum contributions; therefor IRA accounts would have limited total values.
The basic idea underlying the rule allowed individuals to shelter a nominal amount per year from current (ordinary) income tax, have that investment grow in a tax deferred account, and have future distributions made when the individual retired at (presumably) a lower tax rate.
 
In that situation, the most appropriate course of action for individuals allowed them to make IRA contributions and leave them to earn tax deferred until the IRS mandated distribution. However, things have changed. IRAs now include “Rollover” and “Conduit” IRAs that could receive qualified benefits from company benefit plans. Individuals could move payments from such company plans to an IRA with no tax consequences. Thus, amounts going into IRAs no longer faced limits of smaller contributions. IRA accounts could easily grow into accounts worth significant amounts of money—much more than amounts expected based on $3000-$5000 annual contributions. Also, tax rates and surtaxes increased substantially in 2013 due to the Affordable Care Act (Obama care). As a result, some individuals experience significant required minimum distributions from an IRA (because of large account values) and face tax rates at least as great as those paid before retirement!
 
These changes have necessitated a review of IRA withdrawal strategies. It might be beneficial for an IRA account holder to begin drawing from their account prior to the 70½ required minimum distribution date (but after age 59 ½ to avoid the premature distribution penalty). Income tax would be due on such IRA distributions but the entire amount could be rolled into a Roth IRA if taxes on the distribution were paid from current earnings. (Note: Roth IRAs were implemented with the Taxpayer Relief Act of 1997. There accounts do not allow tax deferred contributions but do allow tax free growth and no required minimum distributions.) Notice that such a strategy allows investment of the total amount taken from a traditional IRA (not just the after tax paid amount) into an account that grows tax free and doesn’t have any future required distributions.
 
Should you or shouldn’t you? That’s the question. Can you envision your future income tax rate? How much will you have to withdraw from your IRA? Don’t forget the minimum requirements on defined contribution plans (401(k) and 403(b)) plans that will also impact taxable income in retirement. While we at Paragon Financial Advisors do not prepare tax returns, we can help you analyze the potential advantages/disadvantages and when and how to take distributions from your IRA. Please call us and we can discuss the particular circumstances associated with your IRA. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.


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