You may be familiar with the term “exit strategy,” but perhaps only with respect to the investment world. In fact, it’s also important that you have an exit strategy when it comes to your IRAs. So what exactly does “exit strategy” mean in the context of your IRA?
Traditional IRAs require that once you reach age 70, you must begin taking distributions from your account each year. The minimum withdrawal amount is calculated each year based on your account balance and your age. (These are known as the “Required Minimum Distribution” or “RMD” rules.) The penalties for not following the RMD rules can be severe, and can effectively undo much of the tax advantage you may have gained by setting up the IRA in the first place.
But remember that for traditional IRAs, withdrawals will add to your taxable income. And if you’re subject to the Required Minimum Distribution rules, you’ll be forced to take those withdrawals (and pay the taxes that are due), regardless of whether or not you actually need that money to fund your retirement expenses.
On common technique for avoiding the RMD rules is to convert a Traditional IRA to a Roth account. Roth IRAs are not subject to the rules on RMDs, and you can even continue contributing to a Roth IRA after you reach age 70½ – something that’s prohibited for Traditional IRAs. This means that an individual who has other resources to draw upon to fund their retirement can accumulate significant wealth and accomplish various estate planning goals using the Roth IRA structure.
It’s true that converting to a Roth account will incur an immediate tax liability, but the various advantages of the Roth IRA may significantly outweigh that liability for many account holders. Furthermore, while contributions to a Roth IRA are never deductible, individuals may find that if they’re covered by a retirement plan at work then they may not be able to make deductible contributions to a Traditional IRA either (if their incomes are above a certain level).
Speaking of estate planning, another way that IRA holders fail to prepare an exit strategy is by giving inadequate consideration to the beneficiary designation on their accounts. It’s common for account holders to name their spouse as their primary designation, but then fail to name their children or grandchildren as contingent beneficiaries.
If an IRA passes to an individual’s estate, then when the assets are distributed to the individual’s heirs those heirs must generally take distribution of those assets within five years (thus accelerating the tax liability). But if those same beneficiaries were designated as such within the IRA account, they’d be able to choose a longer term distribution of funds, thereby delaying the tax liability (and letting the assets continue to grow on a tax-deferred basis).
Again, there are various advantages that a Roth IRA can provide over a traditional structure when it comes to estate planning. By opening a self-directed Roth IRA with a custodian such as Quest Trust Company, there are even more opportunities to maximize your retirement savings.