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Taxes on your Retirement Savings

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July 31, 2011 by wcobserver

We typically think retirement savings should be tax free. After all, the charm to that 401-K or IRA account is the tax break. You get to put the money in “before-tax” and the growth is also free of tax, right? Actually, it might be more correct to say it’s “tax-deferred.” Retirement accounts and other Tax-Qualified pensions are not really tax-free. You’ll have to take the money out some day, and when you do that you’ll pay tax on the amounts withdrawn.

In fact, the tax rules generally require you to begin withdrawing your money at the tender age of 70 ½. There are strict rules about “Required Minimum Distributions” (RMD). After that age, if you neglect to make the stipulated minimum withdrawals, you’ll get hit a tax penalties equal to 50 percent of any shortfall.

So just what are the rules for RMD’s? Let’s say you’ve recently retired, and you have a fat IRA in addition to your Social Security and pension. Or maybe you’re a teacher and you have a 403B “teacher annuity.” It works like this; the government has a Uniform Distribution table (Google “RMD table”) which you must use to calculate your RMD, unless you have chosen a lifetime annuity payment. You may withdraw more than the minimum, but not less.

Why the rules? Reason is Uncle Sam wants you to take that money out so he can tax it. You can’t sit on it and pass it on to the next generation without paying any taxes. So how do you know if you’re taking the required minimum?

Here’s how the calculation works: Say you’re 71 this year, you look up your number in the Uniform table, and see that the factor for your life expectancy is 26.5. You then take the total of your retirement account(s) as of the previous Dec 31. (Do NOT include your spouse’s accounts) Further, suppose at the end of last year you had a balance of $198,500 in your 401-k and you have two IRA accounts of $75,000 and $37,500 respectively. All those add up to $311,000. Divide that by 26.5, and you arrive at a figure of $11,735.85. That’s your RMD for the year. I would round it up to $12,000, in case of a mistake. You may withdraw it all from any one of the accounts, or proportionately from all of them. Next year when you’re 72 the factor is 25.6, and is down to 14.8 at age 85. Of course, the diminishing factor means you have to take out a larger slice each year. Yes, you get to make a new calculation every year!

Although it’s not that complex, many people find this calculation somewhat daunting. You could lean on the person preparing your taxes, or you could ask the institution holding your account to make the calculation for you. A caution point, in that case, is the insurance company or bank only knows about the account they are managing; not necessarily about the others. If you have multiple accounts, it is your responsibility to make sure you tally everything up. Maybe if you have a good Insurance agent or Broker they might figure it out for you. Milt does this, but most don’t want the responsibility.

One way to simplify all this is to take a life annuity settlement, which automatically meets the RMD. All you have to do then is go to the mailbox each month and get your check. In that case, the insurance company sends a 1099 to the IRS, which means you still get to pay your taxes.

But back to the RMD withdrawal plan…any balance left is taxable income to your beneficiaries at your death. That is, unless you did a Roth plan. In that case, you paid your taxes when you earned the income, and there’s never any tax later. Which is better? If your tax bracket was higher during your working years, you come out better deferring the tax. If you’re going to be richer after you retire, you’ll come out better with the Roth plan.

Either way, it’s a nice problem to have.

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