Making the Most of Retirement Planning

One of the most critical and frequently overlooked issues in retirement planning comes after most people have retired. Beginning on the April 1 occurring after you reach age 70 ½, you must begin taking minimum distributions from your retirement plan. How you structure these distributions can have a profound effect on your own retirement and even more on what you leave your heirs.

There are some basic retirement planning steps you can take to get the most out of your retirement plan. Failing to follow these basic strategies could wind up costing you and your heirs many thousands of dollars in unnecessary taxes. A case study of how poor retirement planning can cost one’s heirs appears at the end of this section.

Calculating Your Minimum Distribution
Congress created the rules governing the minimum distribution of retirement plan funds to encourage saving for retirement and to allow retirement assets to build up tax-free during the plan owner’s working years. You do not pay tax on income you put into a retirement plan when earned or on investment income on the account itself. However, the funds you withdraw upon retirement are treated as taxable income in the year you take the distribution. And if your children withdraw the funds that they inherit from you, they will be taxed on such distributions at their income tax rates.

Since the idea of retirement plans is to encourage taxpayers to save for retirement, lawmakers imposed a penalty for early withdrawal – before age 59 ½ — and a penalty for failure to withdraw once the owner reaches retirement age — after age 70 ½. Until recently, there was also a penalty for excess withdrawals — in other words, for those who saved more than they need for retirement — but that penalty has been repealed. These penalties apply to all tax-advantaged retirement plans, including Individual Retirement Accounts (IRAs), Keogh accounts, 401(k) plans, and pensions.

The withdrawal penalties are in the form of excise taxes. Early withdrawals, those taking place before you reach age 59 ½, are subject to a 10 percent excise tax (with limited exceptions). In other words, you pay the government 10 percent of the amount withdrawn in addition to the taxes that would normally be due upon withdrawal. As for late withdrawals, you must begin taking distributions by the April 1 occurring after you reach age 70 ½ (known as the required beginning date), or pay a whopping 50 percent excise tax on the amount that should have been distributed but was not.

The Designated Beneficiary
It used to be that the first rule of retirement plans was to always designate a beneficiary. While it is still important to designate a person or institution to inherit your retirement accounts, the choice of beneficiary is not nearly as critical a decision as it once was.

First, as explained above, your choice of beneficiary generally won’t have an impact on your required minimum distributions. Second, you can change your beneficiary down the road. In fact, your beneficiary can even be changed after your death by the executor of your estate. The date for determining designated beneficiaries is September 30 of the year following the year of your death.

All this means that your designation of a beneficiary (or failure to name one) will rarely result in the kinds of tax-planning disasters that were common before. In most cases, your heirs will be able to take steps that will ensure deferral of taxes on retirement accounts over their lifetimes. But these changes also mean that it is doubly important that your heirs consult with a qualified elder law or tax attorney to ensure that they are making the best decisions regarding beneficiaries from a tax-planning standpoint.

Designating a Trust As the Plan Beneficiary
For tax planning purposes, many couples with estates larger than $2 million (in 2008)set up “A and B” trusts to take advantage of the unified credit of the first spouse to pass away. Where a large portion of the estate consists of retirement plans, it often makes sense to have them payable to the trust rather than to the surviving spouse. Unless the trust is properly drafted, however, it won’t be considered a designated beneficiary and the surviving spouse will have to withdraw all the retirement plan monies within five years. Making sure the trust is carefully drafted is complicated and requires the services of an attorney experienced in such matters.

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