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		RETIREMENT PLAN DISTRIBUTIONS: WHEN To Take Them
		When must you start withdrawing the funds in your retirement plans? And what happens if the fund aren't withdrawn before you die? To what extent will your heirs be taxed? The rules are complex but there are ways the savvy taxpayer can maximize the tax shelter.

TABLE OF CONTENTS

Withdrawal While You're Alive
Withdrawal After You Die
Tax Planning
INFOSOURCES

The basic rule is that you must begin withdrawing funds—and incurring taxes on these withdrawals —no later than April 1 of the year after you turn 70-1/2. This rule exists so that retirement funds will be distributed—whether or not spent—during what for most people is their retirement years.

An exception to this general rule is that, where your retirement plan permits, you do not need to begin these mandatory withdrawals until you retire, if you are still employed when you reach the mandatory withdrawal age. The exception doesn't apply where you're a 5% or more owner of the business that provides the plan, or to withdrawals from traditional IRAs--in those-cases you are subject to the mandatory withdrawal rules.

Preserving the tax shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution—or the smaller the amount you must withdraw—the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows, to maximize assets, and the shelter, for the next generation.

The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter that started out to aid your retirement.

The rules are complex, but here's a general overview of the timing of retirement plan distributions which will help  avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules, professional guidance in this area is strongly suggested.

WITHDRAWAL WHILE YOU'RE ALIVE

Before You Reach Age 70 1/2

Until the year you reach 70 1/2, you need not take your money out of your retirement account—though your employer’s plan might require you to do so. In fact, there will usually be a 10% early-withdrawal penalty if you make withdrawals from an IRA before age 59-1/2. Between the ages of 59-1/2 and 70-1/2 you pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax contributions you made.

Once You Reach Age 70 1/2

Once you hit 70 1/2, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 70 1/2--say April 1, 2004 if you reach 70 1/2 in 2003. But waiting until April 1 means you must withdraw for two years—2003 and 2004—in 2004. To avoid this income bunching and a possible higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 70 1/2.

IRS has greatly simplified and relaxed the withdrawal rules, effective for 2003 and after. The thrust of the changes is to increase the retirement plan tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.

The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your life expectancy.

Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the year.

Designating a beneficiary is no longer needed to prolong distributions during your lifetime (except where your beneficiary spouse is more than 10 years younger than you). But it's still needed to prolong the distribution during your beneficiary's lifetime, should the beneficiary want that (some will want the money right away).

Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets. You may change the beneficiary later without affecting the amount you withdraw (except for a change to or from a spouse more than 10 years younger).

The rules as to how fast your beneficiaries or heirs must withdraw funds from your account—and pay the income tax—differ, depending on your beneficiary choice.

Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has several options that no other beneficiary has.

• Rollover. A spouse-beneficiary can elect to treat the balance in your IRA as his or her own IRA(like a rollover). This provides the optimal extension of the withdrawal period if your spouse is younger than you, since your spouse doesn't have to start withdrawing funds until he or she turns 70 1/2. At age 70 1/2, your spouse can then use the period in the IRS table—or a longer one if he or she then has a spouse more than 10 years younger. Rollover isn't allowed if a trust is the beneficiary, even if the spouse is the trust's sole beneficiary. A similar extension is allowed for a balance you might leave in a qualified retirement plan: your spouse can roll it over into his or her IRA. And your spouse can roll over a distribution from your retirement plan to another retirement plan in which he or she participates, as well as to an IRA.
• Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the money in the deceased participant's account. There's no 10% early-withdrawal penalty if the spouse takes funds out of your account, but that penalty would apply if the spouse rolled over the money into his or her own IRA and tapped it before reaching 59 1/2.

Someone Other Than Your Spouse. A child or other non-spouse beneficiary can choose to start withdrawals by the end of the year after your death and spread distributions over his or her own life expectancy. This method extends the payout period and the tax deferral. The life expectancy for a 55-year-old, for example, is 29.6 years.

If you name your children as a group as beneficiaries, minimum payouts are based on the life expectancy of the eldest child. On the other hand, if you create a separate share or account for each child, the child uses his or her own life expectancy.

No beneficiary. If you die before April 1 after the year you reach age 70 1/2 having named no beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity), all funds must be distributed —and income taxes paid—within five to six years of your death. Heirs don't get the option of using their own life expectancy.

If you die on or after that April 1 date without having named a beneficiary or having named your estate as the beneficiary, the money must come out by the end of the period remaining under the IRS table. For example, at age 80 the table period is 18.7. On a death at age 80, the estate or heirs would have 18.7 years to complete withdrawal.

Estate tax. There may be an estate tax on retirement funds left to someone other than your spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.

TAX PLANNING

The above discussion covered the general rules as to the withdrawal of retirement plan distributions both before and after you die. Now let's look at some specific tax planning techniques, particularly as regards the estate tax, for minimizing the tax bite when the funds accumulated in your retirement accounts (including pension and profit-sharing plans, 401(k) plans, IRAs and rollover IRAs) are passed on to your heirs.

How Your Heirs Are Taxed

The general rule is that, while there may be an estate tax bite at your death,  inherited assets are received income-tax-free by your heirs. Unfortunately, this general rule doesn't apply to money in a retirement plan. Whoever gets the money will incur income tax on it, unless it’s left to charity (more on giving retirement assets to charity below).

Example: If you gave your wife a $500,000 stock-and-bond portfolio, she will not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will be subject to income tax on it, more or less as you would be if you had received the distributions yourself. (Moreover, there may be a further estate tax as well.)

The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates, except for after-tax investments, which come out tax-free. There are, however, the following key exceptions or qualifications:

• On a lump sum distribution, heirs of persons born before 1936 can sometimes claim tax relief.
• Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments, the interest element is taxable.
• The value of  a stock bonus is taxable when received as ordinary income, less unrealized appreciation and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
• Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir can roll over from your account.
• There’s no early withdrawal penalty on what your heir withdraws after your death, even if the heir is under age 59 ½. But if your spouse is your heir and rolls over your retirement account  to his or her IRA, a withdrawal from the IRA while under 59 ½ is subject to the penalty unless one of the exceptions applies.

The federal estate tax isn’t a major problem for most Americans. Less than 2% of those who die in any year leave an estate that’s hit by estate tax. But the larger a taxpayer's retirement account, the more likely it will be cut down by the federal estate tax on top of the federal income tax described above. The estate tax burden is declining, but many tax professionals doubt that the estate tax repeal (scheduled to become effective in 2010) will occur.

Unlike the income tax, which is collected only as amounts are distributed—and thus is deferred on annuities and the like—the estate tax is collected up front, at the owner’s death, on the present value of the annuity.

One common planning technique—making lifetime gifts to reduce your taxable estate—is impractical for retirement accounts.  Even where you might be able to give part of your retirement account away (as with an IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter survives for your donee. But here are more practical techniques:

• Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the longest period possible.
• If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and income taxes on this amount while achieving charitable goals.
• A charitable remainder trust is a sophisticated way to benefit family, as well as charity, at a reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from the retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is allowed for the present value of what will go to the charity.
• Consider buying life insurance to pay estate tax that can’t be avoided (perhaps because you want a large retirement account to go to someone other than a spouse or charity). The insurance proceeds will be exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to income tax). With proper planning, the withdrawn funds can escape estate tax as well.

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Related FGs

• SELLING YOUR HOME: How To Minimize The Tax On The Gain

• HIGHER EDUCATION COSTS: How To Get The Maximum Deduction

• ANNUITIES: How They Work And When You Should Use Them

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• RETIREMENT PLAN DISTRIBUTIONS: HOW To Take Them

• MUTUAL FUND TAXATION: How To Cut The Tax Bite

• RECORDKEEPING AND CASH FLOW: Effective Techniques

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