IRA Distributions: A Common Mistake

When it comes to taking IRA distributions, many people follow a simple strategy: wait as long as the law will allow before taking any distributions, and then take out the required minimum distribution each year. If you have to pay taxes, you might as well delay the inevitable for as long as possible, right?

As it turns out, for most people, the answer is a resounding “No!” Here’s why.

First, keep in mind that the basic idea behind IRAs and other retirement savings plans is to defer having to pay taxes on part of your income from the time when you are working, and presumably in a higher tax bracket, until you are retired, and presumably in a lower tax bracket.

For most people, as soon as they retire, even if that happens closer to age 59Calculator ½ (the minimum age at which IRA distributions can be taken, as a general proposition, without having to pay a 10% penalty) than to age 70 ½ (the age after which one must begin taking distributions), they are already in what will, in most years, be the lowest tax bracket they will be in for the rest of their lives. If you’re in what will be your lowest tax bracket from then on out, it makes sense to use up that tax bracket every year.

That strategy makes even more sense when you consider the alternatives. IRAs and other retirement plans are never tax-free. They are only tax-deferred. Sooner or later, the money has to be taken out, and taxes will need to be paid when that happens.

If you still have an IRA or other retirement plan balance upon your death, then the beneficiary or beneficiaries will have to start taking distributions immediately. In the case of an “inherited IRA,” the new owner is not permitted to wait until age 70 ½ to start taking distributions. He or she must start taking distributions immediately.

Let’s say that the new beneficiary is your surviving spouse. The concern in that instance is that the tax brackets for a single taxpayer (the tax status your new spouse will have, unless he or she remarries, starting in the year following year of your death) are only half as large as the tax brackets for a married couple. For that reason, it is very possible that the same amount of distribution, if taken by a widowed spouse, will be taxed at a higher rate than it would have been taxed at if the money had been taken out while both spouses were alive.

Let’s say that the new beneficiaries are your adult children. Unless you have lived to a ripe old age, chances are that they (and, if married, very possibly their spouses as well) will still be working, and likely in their peak earning years. It is not uncommon for IRA distributions that the retired original owner could have taken at a 10% or 15% tax rate wind up having to be taken out by their children at a 25%, 28%, 33% or even higher tax rate during their working years.

As with any tax strategy, there is never a “one-size-fits-all” solution. But if you are retired, and you have been following a strategy of only taking required minimum distributions from your IRAs and other retirement plan assets, it would be wise for you to talk to your CPA or other professional tax advisor to determine whether or not that is the right strategy for you.