Have You Made a Plan for Taking Distributions From Your Retirement Accounts?

When most of us think about retirement planning, we tend to focus on the saving and wealth accumulation aspects of the process. That is, we plan how much we think we need to have accumulated by the time we reach our desired retirement age, in order to be able to lead the retirement lifestyle we want.

But a truly effective retirement plan also gives a significant amount of attention to what happens after you’ve built your nest egg and reached your target retirement age. You also need to plan how you’re going to take distributions from your retirement accounts during retirement.

Why Having a Plan is Important.

In short, having a plan for withdrawing money from your retirement accounts is important because you don’t want to outlive your retirement savings. Since it’s impossible for anyone to know when they’re going to pass, it’s important to have a plan, and to build some cushion into the timing of how long you’re going to need to fund your retirement.

Furthermore, this cushion can be vitally important if some of the assumptions you’re making now about your retirement don’t hold true. For example, you might not be able to work as long as you think. Or you might not have accumulated as much as you would have liked, either due to sub-maximal contributions or poor investment returns.

In any case, you’re not likely to be able to reach your retirement goals without giving careful consideration to all the factors relating to that retirement, and coming up with a plan for how and when you intend to take money out of your account.

Are You Subject to the Rules on Required Minimum Distributions?

If your self-directed IRA is set up as a traditional account, then you’ll be subject to the IRS rules on required minimum distributions. These rules state that once you reach age 70½, you must begin taking minimum distributions for your account every year for the rest of your life.

Having to make withdrawals from your account every year can require some degree of advance planning, particularly if you’ve used your account to invest in assets such as real estate or private equity, as these assets often require a significant lead time to be able to liquidate.

Roth self-directed IRAs are not subject to the rules on required minimum distributions.

Don’t Forget About Social Security.

Even if you haven’t been relying on your Social Security benefits when doing your retirement planning, there are still ways that the government retirement benefits program can impact your decision making. For example, you may choose to delay taking your Social Security benefits until you’re past your full retirement age, in order to increase the monthly check you receive from the government. Doing so may require you to withdraw a greater amount from your self-directed IRA until you start receiving benefits, but the long-term payout could make for a more comfortable retirement.

Why It’s Important To Coordinate Your Taxable Investments With Your Self-Directed IRA Investments

Your self-directed IRA can save you a lot of money in taxes, both in the short term as well as in the long run. If your IRA is set up as a traditional account, then (depending on certain aspects of your financial position) you may be able to take a tax deduction for those contributions. And contributions in traditional IRAs will grow on a tax-deferred basis, while the investment gains within a Roth IRA will never be subject to taxation. Many individuals are well-versed with the various tax implications on this level.

But there’s another perspective from which you may want to consider your self-directed IRA tax analysis, and this is the way that your taxable investment accounts, and investment decisions, can impact your self-directed IRA investments.

Let’s first examine just how valuable your self-directed IRA can be. Consider two hypothetical portfolios of $100,000, one a taxable account and the other a self-directed IRA. Let’s further assume that each portfolio is comprised of stock that pays dividends at a 3% rate annually (with those dividends being reinvested), and that the stock price appreciates 5% annually.

At the end of 25 years, the value of the taxable account would be approximately $525,000, while the self-directed IRA is worth over $630,000. This difference in value is attributable solely to the fact that the owner of the taxable account has to pay taxes on the dividends they receive, even if they choose to reinvest those dividends.

If the self-directed IRA is a traditional account, then you will have to pay taxes on those gains, but they’re likely to be at a lower tax rate (because you’re in retirement and perhaps no longer working full time), and they’ll only be taxed when you take the distribution. If your account is a Roth IRA, then you’ll realize the full value of the investment gains.

So one common tax optimization strategy is for an individual to place income-generating investments that would otherwise incur a tax liability into an IRA in order to avoid that liability.

On the other side of the equation, it’s important to note that there are certain tax advantages that are actually disallowed within an IRA. For example, investment interest (such as borrowing funds to purchase a stock investment, or taking out a mortgage to buy a piece of real estate) can be used to offset gains in a traditional account. But borrowing funds is considered to be outside the scope of permissible activities for self-directed IRAs, and the tax benefit of those expenses will be lost inside the retirement account.

It’s the same situation for investments that have tax advantages built in, such as municipal bonds. Because these investments would already be tax-advantaged outside of an IRA, there’s no reason (and it’s actually a missed financial opportunity) to keep these types of assets inside a retirement account.

Understanding the interplay between your taxable investment accounts and your self-directed IRA will put you in the best position to make the optimal investment decisions.

Avoiding the Conflicts of Interest of 401(k)s with a Self-Directed IRA

shutterstock_141467959In recent weeks there has been new talk about introducing stronger investor protections and providing increased opportunities within the area of retirement savings. One of the biggest areas of concern has been a new focus on how individual investors fare in their employer-sponsored 401(k) plans.

Surprisingly, under current law there is no legal obligation for a 401(k) plan provider to put the interests of plan participants before their own. This type of duty is known as a “fiduciary” duty, and without this protection retirement savers may be fighting an uphill battle in trying to build their nest eggs.

Perhaps the biggest conflict is the limited choices that you are provided with a 401(k). For example, you might assume that the 401(k) provider selects the available investments based on their quality or suitability for the 401(k) plan participants. But in fact, in most cases, the fund company provides a fee to the 401(k) provider in order to be listed. And in many cases, the fund company can charge additional fees to the plan participants (often in the form of so-called “12b‑1” fees).

These types of fees, which relate to marketing and preferential treatment within the fund, do not benefit the 401(k) plan participants in any way, and essentially represent an extra charge that lowers their overall return. This is permitted under current law because 401(k) plan providers do not owe a legal “fiduciary” duty to the plan participants.

In contrast, a self-directed IRA custodian such as Quest IRA cannot market any specific investment funds or opportunities to the account holders. Self-directed IRA account owners make all the investment choices, and have the widest possible range of investment opportunities available to them. Rather than being limited to a handful of mutual fund choices (with the potentially inflated fees we discussed above), a self-directed IRA account holder can choose whatever fund or other investment asset is legally permitted under the IRS regulations.

You’re only given one choice when it comes to 401(k) plans – the one that your employer offers, or none at all.

Within the plan that your employer chooses to provide, you’re likely to note a significant limitation in your investment choices. For example, you may only have a single choice when it comes to a particular type of neutral fund or investment philosophy. And forget about being able to select individual stocks yourself; that won’t be available in an employer-provided 401(k).

A self-directed IRA is better because you have the maximum freedom in choosing where you want your retirement funds to be invested.

Finally, with a 401(k) plan, you are essentially locked into the choices and account custodian that your employer provides. There’s no incentive for your plan provider to offer the best service or even to offer a range of fee options, because they know you can’t take your 401(k) business elsewhere. The plan they provide is your only 401(k) option, and you generally can’t move your funds to a different retirement investment vehicle.

But when you do change jobs, you’ll certainly want to use that as an opportunity to roll any 401(k) account you have into a new self-directed IRA.

Fixed Amortization vs. Fixed Annuitization for Early Withdrawals From Your Self-Directed IRA

shutterstock_168346394You probably already know taking a distribution from your self-directed IRA before you reach retirement will generally trigger a 10% early withdrawal fee, in addition to any taxes that may be due. You may also be familiar with certain exceptions that allow you to make penalty free withdrawals, including those for certain medical expenses, educational expenses, or a down payment for first-time home purchase.

But there is also another, lesser-known provision that you have available, known as a series of substantially equal payments. While it is somewhat more complicated than the other exceptions, and requires a longer term financial commitment, it might be suitable for some individuals in particular circumstances.

This exception allows you to set up a program where you begin taking annual withdrawals from your self-directed IRA prior to reaching age 59 1/2. The schedule of payments can be calculated by either a fixed annuitization method or a fixed amortization method, or the more familiar required minimum distributions method.

Fixed Annuitization. The fixed annuitization method provides the starting account balance by a factor taken from the IRS tables, which is based on mortality rates and a “reasonable” interest rate that cannot be less than 120% of the federal midterm rate. Essentially this method calculates the present value of a $1 per year lifetime annuity of a particular amount for the account holder, and divides this amount by the account balance to determine the annual payout.

Fixed Amortization. This method simply amortizes your account balance over your life expectancy. In general, the fixed amortization method yields a lower annual payment than the fixed annuitization method. When determining the “life expectancy” in the fixed amortization method, the account holder can either choose the calculation based on their life, or the joint life expectancy of themselves and their primary beneficiary.

It’s important to note that once this amount is calculated, it will not change. This means that an account that suffers significant investment losses may be depleted early, while an account that performs particularly well might have a surplus of funds.

Required Minimum Distributions. The third method of setting a schedule of substantially equal payments is to use the required minimum distributions method that applies to traditional self-directed IRA holders once they reach age 70 1/2. The biggest difference between this method and the fixed amortization and fixed annuitization methods discussed above is that the required minimum distributions are recalculated every year based on your current account balance.

You are allowed to change between these methods one time during the course of your life.

Once you begin taking substantially equal periodic payments from your self-directed IRA, you must continue to do so for at least five full years, or until you reach age 59 1/2, whichever is later. Therefore, this is not a one-time decision, and not a step to be taken lightly. It might be appropriate for your individual situation, but make sure you understand all the implications before moving forward.

Getting the Most Out of Your Annual Self-Directed IRA Contributions

shutterstock_191070785Contributing to your self-directed IRA every year is vital for your financial future. But not everyone does all they can to extract the most value out of their annual retirement contributions. With that in mind, here are some tips for doing so.

Invest Early. You can get the most out of your annual contributions by depositing them into your self-directed IRA as early in the tax year as possible. Ideally, you should deposit the full annual limit ($5,500 for most taxpayers, and $6,500 for individuals age 50 or over) on January 1 of each year.

Consider two individuals, one of whom makes a $5,000 annual contribution to their IRA every year in January 1, and another who waits until December 31 to make the same contribution. Assuming a modest 6% return, after 20 years the first taxpayer will have over $10,000 more in their account than the second, even though they deposited the same amounts during the same tax years. Simply by virtue of giving their money a little extra time to grow, the first taxpayer has a noticeably larger nest egg. When the rates of return are higher, and the timeframe longer, the difference is even more pronounced.

Diversify and Balance Across Your Other Accounts. Another way to get the most out of your self-directed IRA and the contributions you make each year is to use your account to diversify and balance your investments across all of your accounts.

Think of it this way: there’s a good chance that your overall investment portfolio (taking into account not only your retirement accounts but also your taxable investment accounts) include a range of asset types –income-generating assets as well as non-income generating assets that are more focused on capital gains. By prioritizing more of the income generating assets in your self-directed IRA (where such income will either be tax-deferred or tax-free), you may be able to save significant amounts on your tax bill.

Target Your Retirement Timeframe. You can also maximize the value of the annual contributions you make to your self-directed IRA by taking advantage of the freedoms you have with this account. Self-directed IRAs allow you to invest in highly illiquid assets such as real estate and private equity, which are ideal for some longer-term investors.

The True Value of a Tax Deduction. Remember that many other factors can impact your tax burden. One way to see exactly how much a contribution to a traditional self-directed IRA versus a raw self-directed IRA can save you on this year’s taxes is to prepare two different draft versions of your tax return and compare the numbers. If a $5,500 contribution to a traditional self-directed IRA only nets you a couple hundred dollars savings on your tax return, then you may wish to make a contribution to a Roth account instead. Some taxpayers maintain one of each account type, and then make their contribution to whichever account maximizes their utility in any given year.

The bottom line is to contribute to your self-directed IRA every single year, to the greatest extent possible. You can’t go back and catch up later if you miss the opportunity to make the maximum contribution in a particular year.