For retirees, there’s a magic age in the tax code that you must be aware of: 70 ½. That is the age when so-called “required minimum distributions” begin from most of your typical retirement accounts, like IRAs. It’s very important that you follow the rules for these distributions, because if you blow it, you could be looking at a penalty of 50% of the amount you should be taking. The good news is that most financial service providers (banks, mutual fund companies, insurance companies) will handle the calculations for you. Still, if there’s a mistake, you the taxpayer are ultimately liable.
So 70 ½ is an important date to watch out for. For planning purposes, it may make sense to take withdrawals from your retirement accounts before 70 ½. The conventional wisdom says to let your tax-deferred retirement accounts grow for as long as possible, meaning don’t take any distributions before 70 ½. But as usual, the conventional wisdom doesn’t apply to everyone.
To figure out how much your required distribution at 70 ½ will be, you get to do IRS math. You take your age 69 year-end balance of your retirement account (let’s say you just have one IRA to keep this simple) and divide it by the appropriate IRS age factor. For someone age 70, that factor is 27.4. So let’s assume you have $274,000 in your IRA. Divide that by 27.4, and your required minimum distribution is $10,000. As long as you take out at least that amount, you’re safe. At age 71, the factor changes to 26.5, and you repeat the process every year after that.
Here’s the planning point. It may make sense, from an income-tax perspective, to take withdrawals before you reach 70 ½. For a married couple filing jointly in 2012, you jump from the 15% to 25% tax bracket at about $70,000 of taxable income. If all of your other sources of retirement income (Social Security, interest from investments, etc.) comes to say $65,000, then an additional $10,000 of income (from your hypothetical $274,000 IRA) will push you into the 25% tax bracket. Bummer.
An easy strategy to stay in a lower tax bracket at age 70 and beyond is to take voluntary IRA withdrawals in smaller amounts as early as say age 65. The idea is to reduce the overall size of your IRA bit by bit in your 60s, so that by the time you reach 70 ½, the amount of your required minimum distribution won’t push you into a higher tax bracket. You’re letting some income steam off a little early, so your retirement kettle won’t boil over because it’s too full. By planning ahead in your 60s, you can avoid some income tax pain in your 70s and beyond while at the same time maximizing your retirement readiness!