April 1 deadline no joke
If you turned 70-1/2 in '99, you need an IRA beneficiary and distribution plan
NEW YORK (CNNfn) - This is no April Fool's joke. If you turned 70-1/2 years old in 1999 and you own an IRA, you must make two of the most important financial decisions of your life by April 1.|
This is payback time. April 1 is your "Required Beginning Date," or RBD, when you must select a beneficiary and decide how to make distributions, or withdrawals.
The IRA, for many people, represents the largest single asset of their estate, and therefore any decision you make must be taken seriously. You spent most of your life working for that money. Don't blow it now. Once the clock ticks on the April 1 RBD, your options become etched in stone. They are irrevocable. That is why it is so important to make the right choices now.
These choices will determine how much of your IRA will outlive you, and for how long.
Selection of the beneficiary
Let's focus first on selecting your IRA beneficiary. You must name someone now, or your estate will automatically become the beneficiary. That means the IRA will get emptied more quickly after your death than if you had named a person who could use his lifetime to stretch distributions.
This decision is taken much too lightly by most IRA owners. For example, most married IRA owners simply name their spouse and are done with it. They often do not know what else to do. They are told that if they leave their IRA to their spouse, then the spouse can roll it over and pay no estate tax on the transfer.
Although that sounds good, the statement is not totally true. The correct statement is that you will pay no estate tax yet. All you are doing by naming your spouse as your IRA beneficiary is delaying or deferring the tax until your spouse dies. At that point, the IRA may have grown substantially, resulting in a much larger estate tax bite.
Everyone's situation is unique, and decisions should be made based on individual circumstances. This is why you need to seek out an IRA tax specialist to help you draw conclusions based on your own personal situation.
Ed Slott's irahelp.com.
The first question I ask a married couple is, "Will your spouse need the money?" The first response is usually something like, "Of course I do; I need every cent!" But after things calm down a bit, we are likely to see that this is not always the case.
If the spouse in fact does need the money to live on, then tax planning should take a back seat. Not everything is about taxes. A spouse should never be impoverished in the name of tax savings.
But tax planning is a double-edged sword. You want to plan to leave your spouse enough of the IRA (and other estate assets) so that he or she will be financially secure for the rest of his or her life, but not so much that they cannot possibly use it all, leaving a large estate tax bill for your heirs. Many times, the spouse does not need to inherit the entire IRA, because he or she has sufficient pensions, retirement savings or other assets.
The decision is not an all-or-nothing. Often the best plan is to split the IRA and leave the spouse only the actual amount that he or she needs, leaving the remaining IRA assets in a separate IRA account to the children. This is where planning can yield impressive results.
For example, assume you have a $1 million IRA -- which is not all that uncommon today, given the huge stock market gains IRA owners have enjoyed. Let's say that your spouse has other assets and only needs $400,000 of that IRA.
You can now, before your RBD, split the IRA into two separate IRAs. You have given nothing up. You are merely splitting your IRA into two IRAs. They are both still your IRAs. Many IRA owners fear that splitting IRAs means giving them up. It does not. Now you have one IRA with $400,000 and another with $600,000. On the $400,000 IRA you name your spouse as beneficiary. You can name your 35-year-old daughter -- or some other younger beneficiary, maybe even a grandchild -- as the beneficiary of the $600,000 IRA.
Assuming your other estate assets pass to your wife, as is often the case, then after your death, the $600,000 IRA will pass to your daughter, tax-free. It will pass under the $675,000 federal estate tax exemption. This means that your daughter will inherit 100 percent -- every dollar -- of your IRA free and clear of federal estate taxes. That's one major tax hurdle out of the way for good.
Since most married couples leave everything to each other, this first federal estate tax exemption is often wasted. Now, in this simple example, you have made highly effective use of this estate exemption by passing your IRA through it.
Assuming your daughter is 40 years old when you die, she can stretch out mandatory IRA distributions over another 42-1/2 years based on her IRS life expectancy, spreading out any income tax over that period of time. She will only pay income tax as she withdraws the IRA money.
Your daughter is also not limited to taking only the minimum distributions. She can always withdraw more than the minimum amount, but she cannot withdraw less. If she only withdraws the required distributions each year, the IRA will grow to millions, even at a modest interest rate, all estate tax-free.
This is powerful wealth building. But it does not happen automatically. You must plan and implement it properly.
-- Editor's note: This column originally ran on CNNfn.com on Feb. 3. We are running it again to remind investors about the importance of the April 1 deadline.