2005-08-18 / Business & Finance

Tips On Planning Your IRAs

I recently read a piece of sales literature from a mutual fund company that stated a number of don’ts concerning Retirement Account (IRA) planning. Some of them are worth con-sidering, so let’s begin.

Don’t forget your mate. IRAs were created by the granddaddy of all federal pension laws - Employee Retire-ment Income Security Act of 1974 (ERISA). This was a great piece of legislation.

It was the first federal pension law, and it stopped interstate thievery. Prior to ERISA, companies could escape pension liabilities owed to employees by merely moving across state lines, similar to the way Bonnie and Clyde could escape arrest by crossing state lines after robbing a bank!

Enough of a history lesson: ERISA created the IRA. In those days, you could fund your account with $1,500 and add an additional $250 for a non-working spouse. Over time, Uncle Sam has become more generous. Today you can fund your IRA with $4,000 (if you have that much in earnings), plus another $500 for individuals age 50 and over. Additionally, you can do the same for your spouse if they have no income. Now that’s not chump change!

Another mistake people make is paying the 10% penalty on withdrawals they take form IRAs prior to age 59 1/2. In today’s world, companies no longer feel compelled to retain employees when times are lean, as they once did.

These days, at the first sign of a slowdown, they downsize. OK, you’ve been downsized and the only money between you and the poor house is in your qualified plan, so you take out what you need to get by and pay the 10% penalty.

Wrong! Section 72(t) to the rescue. This section of the Internal Revenue Code allows you to take withdrawals from a qualified plan prior to age 59 1/2 without penalty. As long as you withdraw the money using “a series of substantially equal periodic payments”, there is not penalty. Section 72 (t) states that you must take payments for a least five years or at age 59 1/2, whichever is longer. Therefore, if you are age 50, you must withdraw for 9 1/2 years. By using this concept and correctly splitting and proportioning you’re IRAs, you have a lot of flexibility in taking out what you need without paying a penalty.

Another admonition in the sales piece was, “Don’t have the wrong beneficiaries on your IRA.” This is good advice, and it has many applications. A wrong beneficiary on your IRA could be a former spouse, your estate, or “all of my children.” The problem with a former spouse is obvious. The problem with naming your estate as the beneficiary is that in-come tax is due on the entire account when you die. This eliminates one of the beauties of an IRA, which is tax deferral.

The problem with naming “all of my children” to be the beneficiary of your IRA.

Here’s why. When a non-spousal (spouses get the best deal because they can make the account their own) IRA beneficiary inherits an account, they have a couple of choices on how to take it. One way is to take all of the money and pay all of the taxes rightnow. Another is to wait for five years, and then take the money and pay the tax.

The third, and the most tax efficient, method is to have your beneficiary take an annuity over their lifetime.

If you name “all of my children” as the beneficiary of your IRA, you have forced all of the children to use the age of the oldest child instead of each child using their own age. To avoid this problem simply name each child individually.

Let’s say a 50-year-old child inherits your IRA and they don’t need the money at this time. Since their life expectancy is another 30 years, they could take 1/30th out and leave the rest to grow tax-deferred.

The following year, they would take 1/31st out, and so on, and so on. Let’s use some numbers to illustrate this strategy.

Your child receives an IRA worth $100,000, invests it wisely, and gets an 8% rate of return.

At the end of the year, the account value is $108,000. At that time, they take out the required 1/30th of the account, which is $3,600. When all is said and done, the account is worth $104,400. Each year for the next 29 years, they repeat the process.

Over many, many years, the rate of return will be greater than the rate of withdrawal so the account will grow immensely because of the tax deferral. This is why it is called a s-t-r-e-t-c-h IRA.

As a very wise man, Maury Kartch, my mentor at the National Institute of Finance, once told me when confronted with a problem, “let’s make lemonade out of the lemons.”

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