Individual Retirement Accounts (IRAs) were created to let individuals use the advantage of tax deferral to accumulate funds for retirement until they reached the age of 70 ½. At that point, individuals were required by law to begin withdrawing funds annually because the IRS wanted them to withdraw all of their money and pay all of the taxes before they died. And if a person did not take distributions or if the amount distributed was not large enough, he or she faced a severe tax penalty equal to 50% of the amount by which the required minimum distribution amount exceeded the actual amount distributed.
These distribution rules were fine for individuals who needed this income to maintain their retirement lifestyles, but what if their other sources of income were sufficient to meet their needs? It didn't matter; they still would have been forced to take the sizeable IRA distributions and pay the applicable taxes. And to make matters worse, the amount of the required minimum distributions increased annually. So not only must they pay taxes on increasing distributions they do not need, but they also lose the benefits of future tax deferral and compounding on the amount distributed.
This simply did not fit into the plans of many IRA owners. But fortunately, the rules governing IRA distributions were changed in January 2001. The new rules establish much smaller required minimum distributions and allow individuals to maintain and maximize the benefits of their IRA by making it possible to "stretch" those mandatory distributions over the life expectancies of themselves and their beneficiaries. In short, the 2001 rules allow an individual to withdraw less, pay fewer taxes and ultimately pass greater wealth on to his or her loved ones.
Consider the example of an IRA owner named Jim. Assume that Jim is age 70, has $100,000 in his IRA and does not have a named beneficiary. Under the old rules, (using the term certain method,) Jim would be required to take a distribution of $6,530 from his IRA this year. And each year more and more of his IRA balance must be distributed, which means less money remains to benefit from future tax deferral and compounding.
Under the new rules, however, Jim is only required to take a distribution of $3,649 from his IRA this year. That is 44 percent fewer dollars distributed, which means 44 percent fewer dollars subject to current taxation and 44 percent more dollars that will remain in the IRA to benefit from future tax-deferred growth and compounding. (Jim will face annual increases in the distribution amount under the new rules as well, but the amounts will increase more slowly than under the old rules.)
The ability to leave more funds in an IRA to benefit from future tax-deferred growth and compounding can have a major impact on the future value of the IRA. For example, if an IRA balance of $100,000 is left untouched while earning a 6 percent rate of return for 60 years, it would grow to $3,298,768.99!
The problem was that under the old rules it was difficult, if not impossible, for many IRA owners to stretch out their distributions over long periods of time like 60 years. But the new rules of January 2001 make it possible for individuals to stretch the distributions over the life expectancies of themselves and their spouse, or of themselves and their beneficiaries.
In the case of many IRAs, the owner's spouse is the designated beneficiary. And under the new rules, the age of a spouse beneficiary determines which IRS table is used to determine the owner's required minimum distribution amounts. If the spouse is less than 10 years younger (as well as with most beneficiaries), the owner uses the Uniform Lifetime Table, and his or her payment amounts are based on his or her sole life expectancy. If the spouse beneficiary is more than 10 years younger, however, the owner uses the Joint Life Expectancy Table to determine the applicable life expectancy factor - which results in smaller annual distributions.
But regardless of which table is used during the lifetime of the owner, each spouse beneficiary is entitled to complete a "Spousal Rollover" at the owner's death. The term "Spousal Rollover" means that if the IRA owner dies before his or her spouse beneficiary, the spouse can assume ownership of the IRA and begin new minimum distributions based on his or her own age. This Spousal Rollover option stretches the IRA income over a longer distribution period, and provides an income stream, increased independence and security for the spouse.
For example, assume now that 70-year-old Jim has named his 65-year-old wife, Betty, as his beneficiary. If Jim takes only the required minimum distributions (based solely on his life expectancy because Betty is less than 10 years younger) from his $100,000 IRA over a 15-year period (earning 6 percent interest), he would receive a total of $92,944 from his IRA, leaving an account balance of $121,733. If Jim then died at age 85, Betty could complete a Spousal Rollover, taking new minimum distributions based on her life expectancy until her own death five years later. So in this instance, the IRA would pay out $92,944 during Jim's lifetime and $39,977 to Betty, and still have a balance of $121,503 at Betty's death. Using this method, the total overall value of the IRA has been stretched to $254,474.
However, if Jim and Betty do not need the distributions from this IRA to support their retirement lifestyle, Jim can choose instead to name his 35-year-old son, Steve, as his beneficiary. (In several states, in order for someone other than the spouse to be designated as the primary beneficiary, the spouse must waive his or her community property interest and give his or her consent.)
As expected, Jim predeceases his son. As the beneficiary, Steve (now age 50) inherits the IRA and can elect to stretch the distributions over his own life expectancy. As a relatively young man with a long life expectancy, Steve's annual distributions are less than what his father had been required to take. This means a greater amount of money is left in the IRA to continue to benefit from future tax-deferred growth and compounding. So over Steve's life expectancy of 33 years, he would receive a total of $419,292 from the IRA.
And depending on individual circumstances, there may be an opportunity to stretch the distributions over an even longer period of time, thus taking advantage of even greater tax-deferred growth and compounding. Here's how - assume that instead of naming his son as his beneficiary, Jim chooses his 23-year-old granddaughter named Beth. As long as Jim predeceases his granddaughter, Beth will inherit the IRA. And as the designated beneficiary, Beth can elect to stretch the distributions over her own life expectancy. At the end of Beth's life, the original $100,000 IRA will have been stretched over 76 years to a total value of $1,462,118!
So as one can see, the new rules provide a tremendous opportunity for individuals to use the tools of tax deferral and compounding to create a legacy that will continue to benefit their loved ones for years and even generations to come.
