In our third and final installment on IRA accounts, let's take a look at some more advanced topics and less well-known strategies open to retirement account holders.
• Inheriting an IRA. Most people are aware that a surviving spouse may directly assume ownership of the deceased spouse's retirement account and treat it as his or her own. However, the rules are different for nonspousal beneficiaries, and knowledge of the options is essential.
Generally, the balance of a traditional (pre-tax) IRA must be distributed within five years, and reported as taxable income. No early withdrawal penalty applies in this case regardless of age. This is often satisfactory if the account value is small or the recipient is in a low tax bracket.
If the account is substantial, you may prefer to take advantage of the "stretch" option. This allows the account to be distributed systematically over the recipient's lifetime by taking calculated required minimum distributions each year. For a relatively young beneficiary, the annual withdrawal may be proportionately small, providing some current income but also exploiting the tax-deferred status of the remaining investments to enhance future growth.
There could also be occasions in which a surviving spouse may not need the assets and wishes to avoid the tax liability associated with minimum distributions after age 70 1/2. In this case, the spouse may choose to disclaim or reject the inherited IRA, allowing it to pass directly to any contingent beneficiaries named on the account.
• Consider spending IRAs first. We are conditioned to delay taxable distributions from traditional IRAs as long as possible. But if your objectives include leaving a legacy for your heirs, it might actually make sense to speed up your IRA withdrawals and let your taxable assets ride.
If you are retired and over 65, it is likely that the total tax burden on IRA withdrawals could be lower on you than on your kids, especially if they inherit your retirement account during their peak earning years. Meanwhile, assets invested for long- term capital gains like stocks receive a step-up in cost basis at your death, passing tax-free to your heirs up to the current estate exclusion of $5 million. If your objective is to maximize the value of the inheritance, your tax adviser might recommend living off your IRA and letting your taxable account grow, provided it is sufficiently oriented toward appreciation.
• In-service withdrawal from your 401(k). Most employer plans allow early withdrawals to address specific hardships. But some plans may allow you to transfer at will some or all of your balance into a rollover IRA while you are still working and contributing to the plan. This option might be preferable for sophisticated investors seeking broader investment options than the limited number of funds offered by the employer's plan or those who wish to engage an adviser to manage the assets.
Not all 401(k) plans allow for in-service withdrawals, and those that do generally impose a minimum age requirement (usually 50 1/2). Your benefits department can tell you if this is an option, and you must follow the rollover rules acidulously to avoid costly penalties and taxes. Be sure to consult a professional before proceeding.
Christopher A. Hopkins, CFA, is a vice president at Barnett & Co. Advisors.