The aging of your clients is generally a good thing for them, especially when compared to the alternative.
But the older they grow, the more likely it is that they and their retirement accounts will be subject to required minimum distributions (RMDs).
Here's what you need to know about taking RMDs from IRAs, and why it's a process that requires year-round advance planning to manage the damage mandatory taxable withdrawals can do to your clients' wealth.
Remedial RMD education
You probably know that owners of traditional IRAs are generally required to begin taking distributions from the accounts by April 1 in the year after the owner reaches age 70½.
The minimum amount is usually based on the balance of all of the client's IRAs at the end of the preceding year, then dividing that figure by the client's life expectancy factor (as determined by the IRS).
The actual number can be calculated online at such sites as www.dinkytown.net/retirement.html, or by using the worksheet in IRS Publication 590, Individual Retirement Arrangements (IRAs) available at www.irs.gov.
Whatever is withdrawn is considered ordinary income, and is potentially taxable as such.
Don't let the apparently mundane nature of RMDs fool you — there are plenty of ways the process can cause more pain than necessary to IRA owners.
The worst prospect for harm comes when those over 70½ don't withdraw the entire required amount each year.
The IRS can impose a 50 percent excise tax on what should have been taken out (but wasn't) — and the IRA owner still has to withdraw (and potentially pay taxes on) the neglected amounts.
Clients who have IRAs scattered among several firms are particularly vulnerable to this penalty, since it's more likely that one or more accounts might be forgotten when making the annual RMD calculations.
Of course, a mutually beneficial solution to this problem is to take responsibility for all the RMDs of your client's IRAs, on the condition that the accounts are transferred to your oversight.
Insult added to injury
Another harm that RMDs can trigger is when poor planning makes clients incur more in taxes than they have to, want to, and expect to pay.
It begins with the deadline for the first RMD (again, it's the April 1 of the year after the IRA owner turns 70½).
That withdrawal is technically for the previous calendar/tax year. And since another RMD is due again before year-end, unwary IRA owners could end up with two taxable distributions in one tax year.
So it may be wiser (and less taxing) to spread the first two RMDs over two years, by taking the first RMD in the calendar year in which the client turns 70½.
A larger threat looms when a client's annual RMD, which by design will grow larger with each passing year, is added to more RMDs from a spouse's IRA, and/or one the clients have inherited.
When combined with any Social Security or pension payments the client is already receiving the supposedly minimal distributions can quickly maximize a client's tax bill.
Despite the seemingly mandatory nature of RMDs, there are several options clients have to lower the taxes that RMDs would otherwise trigger, even before the IRA owner reaches 70½.
Reducing future RMDs begins with reducing the size of the IRA — specifically by converting part of the IRA to a Roth IRA each year.
The act is especially attractive if you and your clients believe that their situation or the laws could mean the RMD would be taxed at a higher rate in the future than the conversion would be taxed today.
An optimal amount is whatever takes the clients right up to the top of the 15 percent federal income tax bracket (it's the figure on Line 43 of the 1040, and in 2011 the 15 percent bracket ends when that number exceeds $69,000 for married couples filing jointly, and $34,500 for single filers).
The conversion can be especially advantageous if performed after a client turns 59 ½, but before initiating Social Security payments.
First, the absence of Social Security income means that more of the IRA can be converted now to the Roth IRA, without exceeding the top of the 15 percent federal income tax bracket.
You probably recall that Roth IRA distributions are not included in the formula that determines if Social Security payments are taxable.
Therefore, once the client begins receiving Social Security in retirement, having a larger portion of his retirement money sheltered by a Roth IRA makes it less likely that any extra money needed will trigger taxes on his Social Security payments.
Then when he turns 70½ and has to start taking RMDs, the reduced IRA balance means that he will have a lower RMD, and therefore a lowered chance that the RMD will trigger taxation of his Social Security payments.
Required minimum distributions from IRAs can't be converted to Roth IRAs. But amounts above the RMD are still eligible to be converted to Roth IRAs, and should still be strongly considered in years that the clients have little or no taxable income.
IRA owners over age 70½ who don't itemize their tax deductions should use RMDs to fulfill any charitable intentions, rather than making direct contributions in the form of a check.
In 2011, IRA owners can transfer up to $100,000 from their IRAs directly to a qualified charity, and the donation will be free from income taxes even if the clients don't itemize.
The law authorizing this tactic has yet to be extended to the 2012 tax year and beyond, but based on historical actions, it's very possible that it will be allowed in future years.
When good intentions go bad
If you think IRA RMDs are confusing and fraught with hazard, you won't believe what can go wrong (and right) when an IRA owner dies with money remaining in the account.
So next month we'll address how to ensure that IRAs go to whom the owners would most prefer, and in a manner that excludes Uncle Sam from the process.
Kevin McKinley CFP is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid A Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.mckinleymoney.com.