| BUSINESSWEEK ONLINE : JULY 19, 1999 ISSUE | ||||||||
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| COVER STORY
The Many Ways of Unscrambling a Nest Egg Options for taking money out The day you turn 70 1/2 will be a watershed event in your financial life. Until that point, you are encouraged to build your retirement nest egg through tax-deferred savings plans, such as 401(k)s and individual retirement accounts (IRAs). Once you hit 70 1/2, however, federal law says that you must start drawing those assets down. With only a few minor exceptions, you have until Apr. 1 of the year after you hit 70 1/2 to begin taking what the government calls ''required minimum distributions.'' If you should happen to miss the deadline, the Internal Revenue Service can levy a 50% penalty on the difference between the amount that you actually withdrew and what you should have taken. Just as frightening is the prospect of dying without adequately planning for the transfer of your remaining nest egg to your heirs. ''For most people, this is their single largest asset,'' says Ed Slott, who publishes Ed Slott's IRA Advisor (800 663-1340; www.irahelp.com). If you don't know the rules, he warns, you could ''lose 70% to 80% of it to estate and income taxes.'' The first thing you must do, preferably at the time you first set up the account, is to name a beneficiary. This is a must--even if you are a single person. That's because the IRS permits those who have named a beneficiary to calculate a joint life expectancy when figuring out their withdrawals. Since the life expectancy of two people is necessarily greater than one, this is a good way to spread payouts over more years. It also minimizes the amount you must take each year, cutting the income tax due. And it gives your assets more time to grow tax-deferred. Choosing your estate as the beneficiary would be a big mistake. This can happen, however, if you don't pick anyone and the plan names your estate by default. Because an estate has no life expectancy, you would have to spread withdrawals over your lifetime alone. A second error is to automatically designate your spouse as beneficiary. If your goal is to leave as much as possible to the next generation, you're better off selecting a younger beneficiary. Still, keep in mind that if your estate is more than $650,000, your retirement fund could get hit by both estate and income taxes if you leave it to someone other than your spouse. No matter whom you name, review the decision before you turn 70 1/2. If you change your mind after you start taking out money, IRS rules say your annual drawdowns can only increase. REQUIRED SUM. When planning withdrawals, keep in mind that delaying into the next calendar year after you turn 70 1/2 can backfire. That's because those who wait must take two withdrawals that year, a move that can push some into a higher tax bracket. To figure out how much money you're required to withdraw, take your account balance as of Dec. 31 of the prior year and divide it by your and your beneficiary's joint life expectancies. You have three ways to determine joint life expectancy. The simplest is called ''term certain.'' When you reach 70 1/2, look up the combined life expectancy in IRS Publication 590. Then, for each successive year that passes, you should subtract 1 from the previous number. If a 71-year-old man with a $500,000 IRA names his 68-year-old wife as beneficiary, the actuarial tables say the two have a combined life expectancy of 21.2 years. The first withdrawal thus must be at least 1/21.2 of the $500,000 account, or $23,585. In the second year, the couple must take 1/20.2, and so on. As is the case with any of the three life-expectancy methods, if you die first, your spouse--unlike any other beneficiary--will be able to roll over the money into his or her own IRA, designate a new beneficiary, and design a new payout schedule. But if your beneficiary dies first, the joint term-certain option offers protection for you and your heirs because the original withdrawal schedule remains. The method's downside is you risk running through your savings before you die. ZERO EXPECTANCY. The other two ways of figuring life expectancy give you the security of knowing that you'll always have money in the bank. Joint recalculation is available only to married couples. By recognizing that life expectancy improves with every additional year you live, this method lets you go back to the actuarial tables each year to recalculate. This approach gives you the smallest annual withdrawals and taxes and the longest horizon over which the assets can grow tax-deferred. It also ensures that your nest egg won't run out until the tables end at age 115. The problem with this method is that if your spouse dies first, his or her life expectancy drops to zero. That leaves you no choice but to base future withdrawals on just your lifespan. The rules also force your heirs to withdraw the balance when you die, triggering a big tax bill. For this reason, many experts advise clients to stay away from joint recalculation unless they plan to leave the money to charity. A third choice offers a middle ground. Called the hybrid method, it permits one person to recalculate while the other uses term certain. If your beneficiary is someone other than your spouse, be aware that the IRS permits only account owners and spouses to recalculate. So a child, grandchild, or friend has no choice but to elect term certain. But if you opt for the hybrid method and your beneficiary is your spouse, Slott recommends putting the younger person on term certain. That's because when both parties die, the heirs get to complete the life expectancy of the person on term certain. Whichever method you choose, don't forget to inform your plan's custodian. If you don't, you may wind up with the default option, which is often recalculation. ''REALITY CHECK.'' Which plan is right for you? If you need the money to retire comfortably, pick the recalculation or hybrid method to make sure your savings last as long as you do. Then, ''do a reality check'' on your heirs, advises Christine Fahlund, senior financial planner at T. Rowe Price Associates in Baltimore. For example, if your son needs money to buy a house, he is likely to cash out soon after inheriting your account. As such, you won't penalize him if you recalculate--a method that mandates a lump-sum payment to heirs. But if you don't need the money and want to give as much as possible to the next generation, use the term-certain option and name a young beneficiary. You won't reap the maximum benefit while you are alive, because the IRS forces you to assume the age gap between you and a nonspouse beneficiary is no more than 10 years. Once you are gone, however, your beneficiary can take withdrawals based on his or her actual age and life expectancy--minus the payouts that you have already pocketed. If you have several goals or beneficiaries, you can divide your account. If you are intent on leaving your tax-deferred retirement account to an heir, go ahead, but use your $650,000 estate-tax exemption for other assets. If you give your heirs an IRA, they will owe as much as 39.6% of the account to the government to pay the income taxes due upon withdrawals. Heirs will get much greater mileage out of $650,000 worth of stock or cash because income taxes have already been paid, says Jere Doyle, estate planning manager at Mellon Private Asset Management. The only two ways around the rules are to keep working for your current employer or open a Roth IRA, which requires no distributions during your lifetime because it accepts only aftertax dollars. Withdrawals from your employer's 401(k) plan can be postponed until Apr. 1 of the year following retirement. But when it comes to traditional IRAs, you can't delay, whether you are working or not, says Steven Lockwood, a New York pension attorney and co-author of Individual Retirement Account Answer Book (Panel Publishers, $136). NO-BRAINER. If you die before you reach the age of 70 1/2, your beneficiaries have choices: If they do nothing at all, the ''five-year rule'' kicks in, requiring the account to be drained within five years. Heirs can also notify their plan's custodian that they intend to spread the withdrawals over their lifetimes. Margaret Malaspina, author of Don't Die Broke: How to Turn Your Retirement Savings into Lasting Income (Bloomberg Press, $21.95), says that this can turn even quite a small inheritance into a significant source of wealth. Assuming there's an 8% annual return, Malaspina calculates that a 40-year-old who inherits a $20,000 IRA would realize $115,000 of income over his or her lifetime, with $57,000 left in the account at death. For beneficiaries who are also spouses, the third option is to roll inherited money into a new IRA. This is a no-brainer unless the spouse needs the money to live. In that case, money can be taken penalty-free, but only if it is left in the original account. Whatever your situation, remember that this topic is capable of confusing even the experts. So seek help from financial planners, accountants, or others--but make sure you are not getting cookie-cutter advice. To design a successful strategy, your planner must consider your needs not only in retirement, but beyond. BY ANNE TERGESEN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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