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Don’t let IRS gobble your IRA with tax penalties

The IRS could take a big bite from your IRA if you’re retired and don’t meet the minimum withdrawal.

As the end of the year approaches, older investors need to pay close attention to the amount of money they have to withdraw from their retirement accounts — whether they like it or not.

So-called Required Minimum Distributions are a fixed amount that must be taken out of a retirement plan each calendar year once the beneficiary turns age 70½. RMD rules apply to all employee-sponsored retirement plans, including a 401(k), 403(b) and IRA — and if you don’t meet the minimum by Dec. 31, you could wind up paying steep tax penalties as a result.

While it may sound a bit silly that the IRS forces you to spend your own money in retirement, especially to those who don’t have a huge nest egg, the idea is to prevent the well-off from taking advantage of favorable tax treatment for retirement funds. After all, if you can keep growing your money tax free forever in an IRA … why not simply let it ride and leave a massive inheritance for your heirs, grown with the help of tax-free investment?

So, if you are lucky enough to have a big retirement account and have hit age 70½ in 2013, make sure you remember to tap that IRA this year before the tax man does on your next return.

The specific amount of your RMD will vary, and is determined by dividing the total market value of your retirement account by a life expectancy figure provided by the IRS in its Publication 590. There are also other factors, including your beneficiary status should you have a spouse who is eligible to share in your retirement funds, or your employment status, should you continue to work very late into life.

But, as a general rule, required minimum distributions start at about 5% of your retirement fund and move slowly higher as a percentage over time.

Here’s a working example: You’re single and just turned 70½ in 2013, with $500,000 in your IRA. IRS gives you a divisor of 27.4 for your nest egg — meaning you must withdraw $18,248 in the calendar year, or roughly 3.7% of that total.

Now for some Americans, $18,000 or so may not cover living expenses, and they will have to withdraw more or rely on Social Security to bridge the gap. But for those who have more than enough, it is wise to use the retirement funds first to avoid penalties that may be as high as 50% of what the IRS determines should have been withdrawn.

So using the previous example, if you have $500,000 in your IRA and don’t spend a penny, you could see Uncle Sam claim about $9,124 of your cash anyway.

Admittedly, many Americans are woefully underprepared for retirement and don’t have the luxury of simply forgoing distributions from their retirement accounts. According to the AARP, the average 401(k) balance of those over 55 was $255,000 to start 2013, meaning a required minimum distribution of about $9,300 a year to start — hardly a king’s ransom.

But if you’re in the enviable position of having enough resources beyond your IRA or 401(k) to live on, pay close attention to the RMD requirement because you could wind up getting charged big-time for not accessing your retirement cash after age 70½ as the government intended when it approved favorable tax rules for these plans.

Remember, you can always take the minimum out and reinvest it. In many cases, this is a cheaper alternative to simply forfeiting half of your RMD to Uncle Sam.

Jeff Reeves is the editor of and the author of The Frugal Investor’s Guide to Finding Great Stocks.

Source:Jeff Reeves, Special for USA TODAY

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