Who will inherit your IRA?

IRAs are unusual. For most of your lifetime, you are penalized if you withdraw too much from your IRA. Later, you are penalized for withdrawing too little.

This is only one of the difficult decisions that must be made when withdrawing IRA funds.

Rita Cron

IRAs are unusual. For most of your lifetime, you are penalized if you withdraw too much from your IRA. Later, you are penalized for withdrawing too little.

Generally, up to age 591/2, if you take money out of your IRA, you incur a 10 percent penalty in addition to regular income tax due on the withdrawn amount. From age 591/2 to 701/2, you are a free agent. You can take out a lot, a little or nothing at all, paying income tax on the amount withdrawn. (Note, there is an exception: You may be subject to a 15 percent, "excess distribution" tax if you take out more than $150,000 a year. Check with your financial advisor for details.) Most people who can afford it choose to withdraw nothing at this point in their lives, maintaining the benefits of tax-deferred growth in the IRA.

A Critical Decision

When you turn 701/2, however, the IRS requires you to begin withdrawing money from your IRA annually. Each withdrawal must be made by December 31, except for the first year when the IRS grants you an additional three months (to April 1 of the following year). They provide this extra time to enable you to carefully make a very important financial decision- how to calculate your annual withdrawal amount. What you choose may determine forever your ability to keep the IRA going during your lifetime and beyond. Make the right decision and you and your heirs may realize decades of proceeds built from tax-deferred compounding. Make the wrong decision and you may miss out on a great opportunity.

Some financial advisers will suggest that you determine the method that allows you to take out the smallest minimum amount at age 701/2. This provides you with flexibility; you can always take out more if you want to; but, beware, withdraw less than your required amount and you will owe a 50 percent penalty on the amount of the shortage.

Who Will Be Your Heir?

Another important question is: who will inherit your IRA? If you choose your estate or a revocable trust, your IRA will become taxable when you pass away and may be subject to high estate taxes. More reasonable choices might include:

Your spouse: Leaving your IRA to your spouse makes sense for several reasons:

- He or she may need the money to live on.

- The estate tax will be deferred.

- Your spouse can put the account in his or her name, choosing his or her own beneficiaries and continuing to defer any federal income tax liability.

For example, Bill decides to leave his IRA to his wife, Judy. When he passes away, Judy, age 76, acquires the account and puts it in her name, assigning their son, Mike, as beneficiary, thereby continuing the tax-deferred benefits of the assets for herself and their son. The only catch is that Judy must assign her beneficiary prior to withdrawing any money.

When Bill chose to name his wife as heir, he also had to decide how his payouts were to be calculated - based on a single or joint life expectancy. He chose joint because it lowered the minimum required withdrawal amount. Then, he had to decide if it was going to be based on a fixed life expectancy or recalculated each year. He chose the annual recalculation because it assured him that he would not outlive his assets.

What would have happened if Judy passed away before Bill? Since couples rarely know who will die first, leaving an IRA to someone other than a spouse is another option. Other logical choices for your IRA beneficiary are:

Children, grandchildren, other relatives or friends: For example, instead of his wife, Bill decides to leave his IRA to their son, Mike. Once again, Bill must decide the payout method prior to making his first withdrawal on April 1 following the year he turns 701/2. The IRS provides a payment table created specifically for joint life-expectancy calculations, where the second person is greater than 10 years younger than the IRA`s owner. After Bill passes away, Mike can use something closer to his true life expectancy, which works to his advantage. Also, Bill may want to consider providing multiple layers of beneficiaries. For example, he may want to name his son, Mike, as the primary beneficiary and Mike`s daughter (Bill`s granddaughter), Sarah, as a secondary beneficiary.

If you have more than one relative or friend you want to split your IRA assets, you can do so. The required payments may come from any account, just as long as the total equals the amount of required withdrawal.

A trust: If you wish to name a trust as your IRA beneficiary, the trust`s heirs must be people, not charities, and it must be irrevocable (which means you cannot change your mind). It also must be set up prior to your April 1 deadline, following the year you turn 701/2.

A charity: If you prefer to give your assets to a tax-exempt charity, your estate gets a full deduction equal to the amount of donation and the charity receives the assets tax free.

Making the Decision

Choosing how to withdraw money from your IRA and pass it along to your heirs is a difficult decision that must be made once you reach 701/2. There are experts who can help you. The IRS offers publications 590, "Individual Retire- ment Arrangements" and 939, "Pension General Rule-Non-simplified Method." Also, it is wise to consult with your investment adviser and your accountant before making a transaction. But, whatever you decide, enjoy your savings for which you worked so hard.

Rita Cron

The author is an investment executive with Advest, Inc., one of the country`s leading regional brokerage and investment firms. Her husband, Christopher, is a prosthodontist in private practice in Louisville, KY.

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