As we’ve stated before, estate planning is more than just distributing property after we’ve gone. The planning part of the equation often involves active engagement and…well, planning. That’s where estate planning intersects with wealth management.
The concept of “inside buildup” is central to wealth management and, by extension, to estate planning. We first addressed this in our entry on 529 Plans a couple of months back. Wealth begets wealth, and to the extent that someone with wealth or assets – even a modest sum – can avoid any loss of that wealth or defer the time when any bill on that wealth comes due (think time-value of money), he is preserving that wealth through inside buildup. For our purposes here the most important bill to come due is taxes. One of the best known ways to defer that tax bill is through an Individual Retirement Arrangement (IRA).
IRAs. It’s almost impossible to find someone who hasn’t heard of them. They are so ubiquitous and the literature about them so voluminous that if you put all the books, periodicals, individual articles, and other materials written about them end to end, they would wrap around the earth more times than…you get the idea. An entire blog couldn’t do justice to the topic – let alone a single blog entry – so let this entry serve as a brief introduction covering the basics – when are they taxed, how much are they taxed, when can you contribute, when can you withdraw, and a few other related topics. We’ll try to cover these by going over a simple example (the simplest?) and showing the basic progression in the life of an IRA from the time a person invests a part of her salary to the time she withdraws that money.
IRA – The Simple Scenario
The simplest scenario – arguably – is this: you establish an IRA held by a custodian (possibly one arranged through your employer) and you have money taken out of your paycheck and deposited into that IRA this year. When tax time rolls around next April, you fill out your return, and you deduct the amount of your IRA contribution from the income on your W-2. This is an above-the-line deduction: that is to say, no matter how large or small your contribution (subject to some caveats including the numbers 0 and 5000), that contribution reduces the amount of your income that is subject to tax that year. This is called a deductible contribution.
Every year, a person can invest a maximum of $5,000 in IRAs. This is a universal limit for each taxpayer. A person cannot circumvent this rule by opening multiple IRAs. If a person opens two IRAs, for example, he is capped at $5,000 in annual contributions. Those two IRAs can receive $2,500 each, or $1 in one, and $4,999 in the other, so long as the total annual IRA contribution by that one person does not exceed $5,000.
The $5,000 cap, however, does have one logical implication, and one exception worth noting here. A married couple may contribute $10,000 annually ($5,000 x 2). Makes sense. That’s the logical implication. The exception worth noting here is the age exception. Once a person reaches age 50, he can contribute $6,000 to his IRA annually (with a married couple capped at $12,000 – naturally).
There are two practical, immediate benefits. Each year, an individual can lower the amount of income subject to tax by as much as $5,000 ($10,000 for married couples) with that number increasing at age 50 (to accelerate growth and, therefore, the amount available for retirement). Second, this starts the process of inside buildup. The amount of money contributed to the IRA will be subject to tax at some time; however, that time should be much later – when the IRA has earned more than enough money to cover that tax bill, and when the nominal amount of money given up this year is worth less in real terms.
Money Invested; Now What? Be Patient
Wait. Sit and wait. Assume you’re 25 years old when you invest. You cannot withdraw that money until you are 59 ½ years old (on pain of penalties for early withdrawal – more on that later). That’s 34 ½ years of time for that money to appreciate in value (compliments of the miracle of compound interest).
What happens if someone doesn’t want to wait to tap all that monetary goodness? Well, that depends. What’s the reason?
If someone doesn’t like their current IRA arrangement, and she wants to switch how the money is invested or who is in charge of investing it, she can choose from many options; we present two. First, she can direct a trustee to trustee transfer. Basically, the investor tells the people in charge of their investment to give it to someone else to have a go. Alternatively, she can take a distribution and reinvest it in another IRA (again, there are exceptions and alternatives even to this rule) within 60 days. This is called a rollover. It MUST be within 60 days in order to avoid being taxed at this time. If she fails to reinvest it in another IRA or other qualifying plan within 60 days, it will simply be treated as a distribution prior to age 59 ½. Also, if a person chooses the rollover option, a certain percentage of the taxable amount will be withheld.
Distributions prior to age 59 ½ are subject to penalties. Such distributions are called early distributions and will be taxed at ordinary income rates on any portion that is taxable. Generally, this is the entire amount in the IRA that exceeds the IRA owner’s basis in the IRA. If no part of the IRA, and no contributions were ever taxed – if all contributions were deductible contributions – then generally the investor has a basis of 0, and the entire amount of the IRA is taxable. Further, on top of the ordinary income tax, there will be a penalty of 10% assessed on the taxable amount.
The Best of Things Come to Those Who Wait (with apologies to Heinz Ketchup)
There’s good news. If you wait until age 59 ½, you can withdraw from your IRA without the 10% penalty. And keep in mind, this is after 9 ½ years of contributing $6,000 annually to your IRA, with the added growth that entails.
Or, you can keep making contributions to your IRA for several more years. But not forever.
Don’t Wait Too Long, Though
Past a certain point, the savings-compound interest-inside buildup party must come to an abrupt end. That end is April 1 of the year following the year in which you turn 70 ½. Huh?
For example. If your birthday is March 1, and you turn 70 years old on March 1, 2013, then you would turn 70 ½ on September 1, 2013. Therefore, no later than April 1, 2014, you must start making withdrawals from your IRA, and you may no longer make contributions to your IRA. It’s IRA entropy. It’s the life cycle writ large on a tax-deferred benefits plan. And in case you were apt to forget this, the IRS won’t hesitate to remind you that you must take minimum required distributions (MRDs). If you do not, the IRS will impose a 50% excise tax on any amount you were required to withdraw, but did not.
Ok, so how much must I withdraw? What is the MRD? The formula is a little complicated – too complicated for prose here – but, in short, it’s tied to a person’s life expectancy. Or depending on the scenario, the person could opt to receive all of the distributions within 5 years.
This, of course, in the simple example provided here, is the end of the IRA life cycle, and it is at this time that distributions are taxed. They are taxed at ordinary income rates. We’ll have a discussion on marginal rates later. (It’s a simple one, but one designed to dispel some widespread confusion about our system of progressive tax rates). You might say that this is unfair, but keep in mind, the principal in the IRA and the earnings on that principal have never been taxed. That prolonged deferral of taxation is the source of the inside buildup that was the reason for embarking on this endeavor in the first place. The piper has to be paid sometime, but at least you were able to put it off – for a good, long while.
That’s our summary of IRAs. We’ll return to these later to discuss some of the nuances of contributions, distributions, which plans can feed into or from them, and some of the other calculations involved, as well as some of the novel instruments which are out there – some apparently good, and some definitely bad.
Estate Law in Texas 