Five-Year Rule

Finance allah shmoop what are ira distributions and well how

do they work Well the big idea here iras or

individual retirement accounts are not tax free Yeah you do

pay tax but only when you withdraw the money out

of the ira Ok so backing up b b pete

you make eighty grand a year is a union told

booth worker in california taking five dollar bills from drivers

and putting them in the little slot thing here Brutal

rigorous highly stressful job Yes you have a pension that

the government you work for contributes taxpayer dollars to pay

for You also have an ira and you contribute five

grand a year to that ira Well that five grand

comes out of the eighty grand you'd normally be fully

taxed on But instead of the eighty grand that the

irs would normally worry about well as faras they're concerned

this year you didn't make eighty grand You made seventy

five grand Why Because you contributed voluntarily five 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 six seven eight nine years until

you retire with five grand contributions year after year after

year you'll have a full million bucks in there By

the time you retire at sixty five and maybe a

little more maybe it'll left and you'll have the option

to start withdrawing from the ira at that point Or

you can wait to start withdrawing the money until you've

hit the maximum age of seventy and a half at

which point the law makes you start to withdraw the

money And there's a whole schedule on when you can

withdraw it how you can withdraw and all that Anyway

That withdrawal process is kind of a big deal because

small tweaks in it make a huge difference Like if

you had saved money beyond the ira i e Your

personal savings accounts and could live on that another five

and a half years Well then if the market followed

historical patterns instead of beginning your ira withdrawals from a

base of a million dollars in there While you have

compounded that million bucks another five and a half years

worth it so that it was then worth maybe a

million six or a million seven by the the time

you were seventeen and a half That's an extra six

or seven hundred grand there that would happen just for

you being ableto wait to start withdrawing Well why is

there a must in there like the government needs to

tax you somehow right So that's why you must start

withdrawing it at some point 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 So why not the cheaper

long term gain rates Well why Because it was income

active income you earned and quote should have been unquote

taxed as ordinary income when you earned it But you

weren't so well now it's time for the tax man

teo You know coming the logic behind the creation of

the ira was that investors in it would be paying

a lower tax rates when they were old I e

making less money as geezers than they did when they

were in the peaks of their careers So under the

progressive tax system whose rates look something like this instead

of paying a marginal rate of say forty three percent

on that five grand that was saved as a geezer

taking out relatively small amounts toe live on Well you're

paying more like thirty percent or less on that marginal

dollar So how much do you take out of the

ira Alright well there's that schedule thing again And the

focus is the minimums you must withdraw What you khun

distribute to yourself more than the minimums But then you

have to take out a set percentage each year So

here's how that works Look at the table here Right

here They ira required minimum distribution worksheet in eight seventy

You're going to divide us Say at a million bucks

in there you're gonna divide that by twenty seven point

four That's the amount you have to distribute this year

Let's say the market went up Whatever One twenty seventh

is more than that even And well then all the

sudden of a million two or a million three Well

by aged call it eighty You have to distribute whatever

that amount is divided by eighteen point seven You get

all the way to one hundred Well you have to

basically divided by six and that's the amount you have

to distribute So let's say you had a i'll say

had six hundred thousand dollars in there at eight hundred

you're going divided by six point three means that six

hundred thousand You have to distribute one hundred grand back

to yourself leaving you five hundred grand Yeah that's kind

of how the system works in more or less Anyway

that twenty seven numbers the denominator in the total assets

in the ira get divided by it And that's the

number The ira beneficiary which would be you if it's

your ira must take out of the ira fund in

this year and notjust how much age matters here In

fact it's kind of everything in this calculation So let's

look at age seventy seven for example the divisor here

is twenty one point two That means that whatever the

total assets worrying the ira as of the end of

the year that amounts divided by twenty one point two

And it's that amount that must be taken out of

the ira and quote distributed to you unquote usually in

the form of your writing A check out of the

ira to yourself that's housed in your normal brokerage account

So let's say that at seventy seven you had a

million bucks from your hard earned scrimping and saving You

take a million dollars in the numerator and divided by

twenty one point two to get forty seven thousand one

hundred seventy dollars It's that amount that you'd have to

take out of the ira and be taxed on at

ordinary income rates and well hopefully live to fight another

day Notice that the divisor increased dramatically as you get

older here like we said And when the iris starts

at age seventy divide by twenty seven point four We

only have to distribute a small amount of doughty yourself

a few percent and be taxed on it But by

eight hundred here Yeah you're doing the six point three

dance Meaning that the government doesn't think you're gonna live

much longer Well why do they do that Yeah well

here's the guy thing is knocking really loud by age

one hundred Very few people live past that age And

those who d'oh well usually have trouble hearing the doorbell