Individual Retirement Account - IRA
What are IRA distributions, and how do they work?
The big idea here? IRAs, or Individual Retirement Accounts, are not tax-free. You do pay tax, but only when you withdraw money out of the IRA.
Ok, so backing up, beep beep beep…
You make 80 grand a year as a union toll booth worker, taking 5 dollar bills from drivers and putting them in the little slot things. Brutal, rigorous, highly stressful job. Yes, you have a pension that the government you work for contributes to, but you also have an IRA. And you contribute 5 grand a year to that IRA.
That 5 grand comes out of the 80 grand you’d normally be fully taxed on. But instead of the 80 grand that the IRS would normally worry about, as far as they’re concerned, this year, you didn’t make 80...you made 75.
Why?
Because you contributed voluntarily 5 grand to your IRA, and it’ll sit in that separate special account, likely invested in the stock market, so that it compounds away, doubling about every 7 or 8 years until you retire. With 5 grand contributions year after year after year, you’ll have a full million bucks in there by the time you retire at 65. And you’ll have the option to start withdrawing from the IRA at that point. Or you can wait until the maximum age of 70 ½ to begin the withdrawal process. Which is kind of a big deal. Small tweaks make a huge difference.
Like...you saved money beyond the IRA, i.e. in your personal savings accounts. And you could live on that another 5 ½ years. Then, if the market followed historical patterns, instead of beginning your IRA withdrawals with a million dollars in there, you’d have compounded that million bucks another 5 ½ years worth...so that it was worth a million 6 or 7 by the time you were 70 ½.
That’s an extra 600 or 700 grand and change, just for being able to wait the maximum time before you must, by law, begin withdrawing.
Why is there a "must" in there? Well, the government needs to tax you...somehow. And remember: that money went into the IRA and sat there compounding, tax-free for decades.
But now, when you take it out, you’ll pay ordinary income rates on it. Why not the cheaper, long-term gain rates? Because it was income. Active income you earned. And “should have been” taxed on as ordinary income when you earned it. But you weren't. So now it’s time for the tax man to cometh.
The logic behind the creation of the IRA was that investors in it would be paying a lower tax rate when they were old, i.e. making less money as geezers than they did when they were at the peaks of their careers.
So under the progressive tax system, instead of paying a marginal rate of, say, 43 percent on that 5 grand that was saved, as a geezer, taking out relatively small amounts to live on, you’re paying more like 30 percent or less on the marginal dollar.
And the focus is the minimums you must withdraw. You can distribute to yourself more than the minimums, but you have to take out a set percentage each year.
And age matters. In fact, it’s kinda everything in this calculation. So at age 77, for example, the divisor is 21.2. That means that whatever the total assets were in the IRA as of the end of the year, that amount is divided by 21.2...and it’s the amount that must be taken out of the IRA and “distributed to you,” usually in the form of you writing a check out of the IRA. And to yourself, into your normal brokerage account.
So let’s say that, at 77, you had a million bucks from your hard-earned scrimping and saving. You’d take 1 million in the numerator and divide it by 21.2 to get $47,170. It’s that amount you’d have to take out of the IRA. And be taxed on it at ordinary income rates and, well, hopefully live to fight another day.
The divisors increase dramatically as you get older. When the IRA starts at age 70, you divide by 27.4... so you only have to distribute a small amount of dough to yourself, and be taxed on it...but by age 100, you have to distribute whatever divided by only 6.3, meaning that you’ll be distributing about 4 times as much as you did at age 70.