As you near retirement, you have a number of decisions to make with your retirement assets, including your IRA assets. There are advantages and disadvantages to each course of action, and each course of action has tax consequences for you or your heirs.
Take Distributions Under Rule 72(t)
Taking distributions under rule 72(t) could be an option if you need the income from your retirement accounts prior to reaching age 59 1/2. Normally, the IRS charges a 10 percent penalty on funds withdrawn from traditional IRAs or earnings withdrawn from Roth IRAs prior to that age. However, if you commit to taking your withdrawal gradually over the rest of your life expectancy or the joint life expectancy of you and your beneficiary, you are exempt from the 10 percent rule.
Cash It Out
If you cash out your traditional IRA, you will pay income tax on the entire amount of the withdrawal. This could push you into a higher income tax bracket, depending on the amount of the withdrawal. The more you take out in a single year, the more income will be pushed into higher tax brackets. As of the time of publication, the highest marginal income tax bracket is 35 percent. However, your taxable distribution could result in capital gains taxes increasing elsewhere in your portfolio for the year. For Roth IRAs, however, your withdrawals are tax-free, provided the assets have been in the account at least five years. If not, then the portion of your withdrawals attributable to gain are taxable as ordinary income.
Let It Grow
For traditional IRAs, you can leave the money in and let it grow, tax-deferred, and unmolested until you turn 70 1/2, or the year in which you retire -- whichever is later. By April 1 of the following year, you must begin to take withdrawals -- called "required minimum distributions." and pay taxes on the income. If you have non-deductible IRA contributions in the account, you will not have to pay income taxes on the amount of your withdrawal attributable to your nondeductible contribution. If you have money in a Roth IRA, you can let it grow, tax free, indefinitely. There are no required minimum distributions for a Roth IRA.
Convert to a Roth
Provided you meet the income eligibility requirements for Roth IRAs, you can execute a conversion of your traditional IRA account to a Roth IRA. You will pay income taxes on the amount you convert. However, after this point, you will never have to pay income taxes on anything in the Roth again, as long as the contributions were in the account at least five years. This may be an appropriate strategy if you believe income tax rates will increase in the future, or if you anticipate being subject to estate taxes, since any money you pay in income taxes now will reduce the amount in your estate subject to higher estate taxes later. As of the time of publication, the estate tax is 35 percent on everything above $5 million. So if your income tax bracket is lower than 35 percent, and you have more than $5 million in your estate, you may be better off moving assets out of your taxable estate by converting a traditional IRA to a Roth IRA.
Open a Self-Directed IRA
You can use your IRA to invest in non-traditional assets, such as closely-held companies, farms, ranches and investment real estate. You cannot use the assets for your own personal benefit, however, without paying income taxes on anything you take out of the IRA. For example, you may own real estate in your IRA, but you may not live in that real estate. You cannot borrow money from your IRA to borrow money, nor use it as collateral on a loan. The rules concerning self-directed IRAs are complex, and self-directed IRAs can be risky. If you are interested in this option, consult a financial professional with experience in handling self-directed IRAs.