If there is one lesson that most of us have learned as a result of the Great Recession, it’s that we all have to take responsibility for our own financial future. The reality is that pension funds are pretty much empty, and the government simply doesn’t have the money to provide for us through social funds. This is why they strongly encourage people to sign up to an IRA (Individual Retirement Account). Not just that, they frequently change the rules and regulations on these accounts to make them even more beneficial for the people.
Most of us would never want to become a burden on our loved ones. We also don’t want to end up living in a virtual poorhouse, struggling to make ends meet. In fact, we would even like to leave something behind for our children, so that they have something to fall back on. All of this is possible thanks to the IRA, because of the “compound interest”, which is something even Albert Einstein picked up on. Essentially, you can put money into an IRA and not pay any taxes on it. This means you basically gain interest in three different methods:
- On the deposits and investments in your IRA
- On the interest earned by those investments
- On the money you would usually have been taxed on
Because of the fact that you earn interest in three different ways, it is advisable to leave money in your IRA for as long as possible. That said, there are rules to stick to, the major one being that you have to start withdrawing from your IRA when you are 70.5 years old. At that point, you have to withdraw a minimum distribution each year, which is based on your total life expectancy. This is known as the RMD or required minimum distribution. If you don’t withdraw that amount, you will have to pay significant penalties. In fact, the tax penalty for not withdrawing from your account is 50%, which means you will essentially lose out on all those benefits.
The IRA Stretch Chart:
It is very important that you work out the best way to withdraw money from your IRA once you have to start withdrawing from it. This is because you will have to pay tax on the money that you take out. Minimizing the amount of tax you pay is important as well. After all, that is your hard-earned money, and while contributing to society is a good thing, you also need to keep some of your money for yourself.
Unless you plan properly, you could end up paying between 35% and 70% of your savings in taxes, including estate, income, and penalty taxes. You don’t want your children to inherit debt rather than savings, after all. Thankfully, you can work you way around it. The best way to do that, is to not leave a huge amount in your IRA until the day you die, as your children will then have to pay a lump sum over that amount. Rather, you should withdraw little bits at a time.
How the Government Is Helping:
New rules and regulations now allow your beneficiaries to withdraw from your IRA, based not on your but on their life expectancy. This means that they can continue to defer taxes, thereby maximizing the money and continuing to enjoy the compound interest as well. This is known as the multi-generation, stretch, extended, or legacy IRA.
That said, you still have to plan things properly and there are two key pitfalls to be aware of:
- Your IRA custodian. It is vital that you know the rules they have in place in terms of IRA distribution. They may, for instance, not accept stretch distributions, demanding that the balance be distributed in full over a five year period. Make sure, therefore, that you know what your custodian’s rules are, and switch if their rules do not appear to benefit you.
- Your beneficiaries. Make sure that your review your designation form yearly, ensuring that all details are up to date. Once you pass away, your heirs can do what they want with the money left in your IRA. If they are clever, they will withdraw the amounts slowly rather than in one lump sum, but that is up to them to decide. There is always the chance that they would be happy to pay 35% in taxes just so they can purchase a new sports car. But, at the end of the day, you left them this money to make them happy, so that is entirely up to them.
There is one way in which you can fully avoid both of the above pitfalls and that is by establishing a trust. This trust will come into force on your death, and states clearly how you want the money contained within it to be distributed. Trusts are fantastic tools that can help you plan a financial future, but only if it is done properly. Mainly, you have to name a natural person, or the full balance will be distributed within a five year period. A natural person has to meet certain very specific requirements in order to be accepted. In fact, there are four specific guidelines that must be followed:
- Your state law must agree to the validity of the trust.
- The trust should be irrevocable when you, as the IRA owner, dies. This means that nobody has the power to change it.
- The trust instrument must properly identify your beneficiaries.
- All documentation required have to be in order.
As complicated as this may sound, it is actually quite easy to complete. Furthermore, doing so brings a number of other key benefits with it as well, including:
- That you are in full control over who gets the money in your IRA.
- That you may not have to pay estate taxes.
- That your IRA is protected from ex in-laws and from future children your ex-partner may have, as well as from new partners of your own children.
- That you protect your beneficiaries form bad habits because they cannot take out a large sum in one go.
- That it protects beneficiaries who receive government benefits.
- That it may stop creditors from taking your IRA.