Removing IRA Funds Penalty-Free and the Purchase of Annuities

Written by Hersh Stern Updated Sunday, November 3, 2024

According to the law, beginning acceptance of your IRA distributions by April 1 of the year after you reach age 70 is mandatory. Failure to do so will result in a huge penalty. However, don't let that fact scare you into being too hasty with your withdrawal decisions; do your research first.

It's true that the law says you have to get that money out of the account, but it also provides a number of choices for setting up those mandatory distributions that could affect the after-tax wealth of your family for decades to come.

Unfortunately, these rules can get a bit complicated. And this is one area on which many financial professionals are under-informed. The IRS has a publication dedicated specifically to this delicate topic (Publication 590 – Individual Retirement Arrangements), but it just gives the confusing mechanics without any advice concerning the consequences or helping you figure out what option is best for you.

Surprisingly, even many of the financial institutions that serve as the IRS's gatekeepers for these rules aren't of much help. In fact, they often give out incorrect information.

To help you make the right decision, here's my quick and easy guide for taking money from your IRA. (The same rules generally apply to company pension plans, though those plans might limit some of your options.)

There are two key decisions you must make regarding your distributions. One decision is whether or not to recalculate your life expectancy each year after age 70. The other is the choice of your beneficiary.

Your goals generally are to minimize required distributions and defer taxes as long as possible. Remember that you can always take out more than the required minimum distribution. So reducing the required distributions does not keep you from tapping the IRA when more money is needed.

Calculating Distributions

Once required distributions begin, the balance in your IRA on December 31 of the previous year is divided by your life expectancy to determine the required minimum distribution for the year. You have two choices for figuring your life expectancy: the recalculation method and the fixed term method.

Recalculation Method

The recalculation method recognizes that every year a person lives, his life expectancy gets a little longer. So each year you will need to consult IRS life expectancy tables to determine your new life expectancy and divide that into the IRA balance. This allows the IRA to last longer than would be possible using the fixed-term method. (For "Joint Life and Last Survivor Expectancy" Tables, call the IRS [800/TAX-FORM] and ask for Publication 939.)

But there is a potential drawback to the recalculation method. In many cases, after your death the recalculation reduces your life expectancy to zero, and requires income taxes to be paid on the entire IRA one year following your death. These taxes are in addition to any estate taxes. If your spouse is the beneficiary of the IRA and survives you, this problem can be avoided. The spouse can roll over your account into a new IRA and start a new minimum distribution schedule. But if your spouse doesn't roll over the IRA, the entire account is taxable one year after your spouse's death. And other beneficiaries don't get the special treatment that a spouse does.

The result is that if the IRA owner and spouse die in their seventies or early eighties and had used the recalculation method, the entire IRA account would have to be distributed and taxed shortly thereafter. That deprives the heirs of most of the amount in the IRA plus the future tax deferral that might have been possible.

Fixed-Term Method

Under the fixed term method, each year after minimum distributions are begun, one year is subtracted from the previous year's life expectancy to determine the current life expectancy. That means your IRA will be depleted by the end of your initial life expectancy.

The advantage of the fixed term method is that the IRA can continue under the distribution schedule after your death. That makes the fixed-term method the better option when your beneficiary is not a spouse or is a spouse whose life expectancy is shorter than yours.

Choosing Your Heirs

Choosing a calculation method is only half your work. You also have to name a beneficiary (or beneficiaries) for the IRA, and that person's life expectancy can be used with yours to calculate the minimum distributions and possibly make the IRA last longer.

Here's how it works. When your IRA has a named beneficiary (simply naming someone in your will doesn't count), instead of looking up your life expectancy in the IRS tables you look up the joint life expectancy of you and the beneficiary. If the beneficiary is younger than you are, the joint life expectancy will be longer than your single expectancy. That reduces minimum distributions amounts and stretches out the life of the IRA.

But there are limits to how far you can stretch out the IRA. When the beneficiary is more than 10 years younger, you assume the beneficiary is only 10 years your junior. After your death, the beneficiary can elect to re-compute the minimum distributions using only his or her life expectancy.

Choosing a younger beneficiary and using the fixed-term method is the best combination of choices for anyone who wants to maximize the life of an IRA. You are assured that the IRA will not be depleted if you outlive your life expectancy, and the beneficiary can continue using the tax deferral for many decades.

The best choice varies from case to case, and the rules are a bit different if you die before age 70. Anyone with a sizable IRA should meet with a financial or estate planner who understands these issues before making a decision. Here are some general rules that might help you:

• An IRA will last longer if you calculate the required minimum distributions using the joint life expectancy of you and a younger beneficiary.
• If your spouse will need the IRA to maintain a standard of living, name your spouse beneficiary regardless of the other issues.
• A spouse who inherits an IRA should roll over the account to a new IRA. That allows the surviving spouse to name a new beneficiary and begin a new mandatory distribution schedule.
• When the actuarial tables say the spouse owning an IRA is likely to die before the spouse who is beneficiary, the recalculation method probably should be used. That ensures that no matter which spouse dies first the IRA should outlive both of them. But it penalizes the next generation if the younger spouse dies first.
• A younger spouse should choose the fixed-term method. That minimizes problems whether the IRA is inherited by either the other spouse or by a younger generation.
• When your spouse will have other assets and will not need the IRA, name a younger individual as beneficiary, such as a child or grandchild. This will minimize required distributions during your lifetime and allow your heirs to benefit from tax deferral for decades to come.
• If your spouse will need some but not all of the money, consider splitting the IRA into two or more accounts so that your heirs can also benefit. Not all mutual fund companies allow one individual to have more than one IRA, so you might have to move the second IRA to another firm.