The Individual Retirement Account is the most common tax-advantaged retirement savings instrument. The traditional IRA account is distinguished by income tax deductibility for annual contributions (subject to income limitations and contribution maximums), mandatory distributions after reaching age 70.5, and taxation on the full amount of distributions as ordinary income.
The IRA is a handy instrument to allow the transfer of investments out of employer retirement plans on a tax-deferred basis after an employee changes jobs or retires. Certain investments in an IRA are prohibited – life insurance is one example. Direct ownership in real estate and other illiquid assets is permitted, but there tax pitfalls to watch for. You cannot borrow funds from an IRA and withdrawals before age 59.5, with a few exceptions, are subject to a hefty 10% early withdrawal penalty.
Delaying distributions from an IRA for as long as possible is good planning to manage income taxes. Consider spending down cash and financial assets held in taxable investments accounts and Roth IRAs first before making elective distributions from an IRA. Distributions from an IRA must commence in the tax year after age 70.5, but the minimum distribution rate is only 3.65% in the first year, growing slowly each year thereafter based on the owner’s remaining life expectancy.
Careful estate planning is required with an IRA to minimize income and death taxes. The first planning rule is to never name your estate as an IRA beneficiary, because it could produce a significant immediate income tax liability to your heirs. Next, your IRA beneficiary forms must be accurate to meet your inheritance goals and to take advantage of the Stretch IRA rules, which allow a non-spouse heir to spread the required distributions over their longer life expectancy.
