When you take money out of a traditional IRA, that withdrawal gets included with your other income for the year and is subject to ordinary income tax (except to the extent that the withdrawal represents a return of nondeductible contributions or other after-tax amounts). The longer you leave funds in these accounts, the more tax-deferred growth you can potentially accumulate.
You’re not required to withdraw money from a traditional IRA until you reach age 70 1⁄2 , and if you do so before you turn 59 1⁄2, there’s generally a 10 percent penalty tax on top of any income tax on the funds you take out.
There are exceptions for taking an IRA distribution before reaching age 59 1⁄2, if it is used for one of several specified life events, or if “substantially equal periodic” payments are taken. These payments, made at least annually under an IRA-approved method and calculated based on life expectancy, may be taken at any age for any reason, provided you continue them for five years from the date of the first payment, or until you reach age 59 1⁄2—whichever takes longer.
Most IRA owners wait to withdraw funds until they reach age 70 1⁄2, when they must start taking required minimum distributions. Although your financial institution can calculate the distribution, you can calculate it by taking the account balance from December 31 of the prior year and dividing it by the factor applicable to your age listed in the appropriate IRS table. These tables may be found in IRS Publication 590-B, available online.<sup>1</sup>
<blockquote>However, IRA owners can convert a traditional IRA to a Roth IRA, regardless of their income.</blockquote>
You have a choice between taking your first distribution in the year in which you turn 70 1⁄2 or delaying the first payment until April 1 of the following year, known as the “required beginning date.” But if you delay, you must take two distributions in the year you turn 71 1⁄2, which can push you into a higher tax bracket.
If you are thinking about withdrawing more than the law requires, take into consideration your finances and long-term goals. In theory, your IRA has the potential to grow more quickly than other investments because it’s not being continually eroded by taxes.
For people with a net worth of $25 million or more, Jim McCarthy, head of solutions delivery at Morgan Stanley, suggests a different strategy: In general, he says, they should consider drawing down their retirement as sets before spending other assets—either by withdrawing the funds themselves or by giving them to charity.
McCarthy reasons that retirement assets “are among the most encumbered and difficult ones to estate-plan with.” What’s more, he says, since funds coming out of these accounts are taxed at ordinary income, investors don’t get the benefit of the lower tax rates that apply to dividends and capital gains.
However, IRA owners can convert a traditional IRA to a Roth IRA, regardless of their income. While the taxable portion of a Roth IRA conversion will be subject to ordinary income tax for the year of the conversion distribution, future distributions from the Roth IRA will be income-tax free if certain conditions are met.
No matter how you invest the funds in your IRA, withdrawals of taxable amounts from traditional IRAs will be taxed as ordinary income, so you won’t have the ability to offset capital gains against losses. But if you invest some of your IRA in stocks, you have the potential to achieve more growth (even after taxes) than you would with lower-paying fixed-income investments.
Jeffrey S. Gerson and Shawn P. Landau are Financial Advisors with the Wealth Management division of Morgan Stanley in New York City. The views expressed herein are those of the authors and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC. <a href=”http://www.sipc.org/” target=”_blank”>http://www.sipc.org.</a> Morgan Stanley Financial Advisors engaged Worth to feature this article. Gerson and Landau may only transact business in states where they are registered or excluded or exempted from registration (<a href=”https://fa.morganstanley.com/ggmgroup/index.htm” target=”_blank”>http://www.morganstanleyfa.com/ggmgroup</a>). Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Gerson and Landau are not registered or excluded or exempt from registration. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP<sup>®</sup>, CERTIFIED FINANCIAL PLANNERTM and federally registered CFP (with flame design) in the U.S. CRC1313712 11/15
This article was originally published in the August/September 2016 issue of Worth.