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Tax-sheltered Funds Must Be Used Wisely

October 3, 2012

Retirement is a time of many decisions. One vital financial decision is about using the tax-sheltered funds we've put away for those special years.

Some retirement plans allow the account owner to select an annuity - a specific annual amount - that will be paid to them during retirement. An alternative is to take withdrawals of any amount after age 59 1/2, varying year by year (distributions before that age carry a 10 percent tax penalty except under certain circumstances).

For those nearing age 70 1/2, an important milestone that affects all of their tax-deferred retirement funds is approaching. By April 1 of the calendar year after reaching 70 1/2, minimum withdrawals based on age must begin if the annuity option has not been chosen.

Current federal regulations set percentages for minimum annual income distributions applicable to everyone. Exceptions apply for those who are still working.

If the required amount is not withdrawn in any year, a 50 percent penalty tax on the difference between what should have been withdrawn and what was withdrawn is owed.

At death, most other estate assets escape income taxes when passed on to heirs, but tax-deferred retirement funds do not. If the heir is required by plan rules or voluntarily requests a lump sum distribution, the account's full balance will be subject to income taxes immediately. An alternative is for the heir to request distributions according to a "spread out" schedule. Income taxes will be owed only on the amounts received.

Also, estate taxes may be owed. In 2012 if the total estate exceeds $5,120,000, 35 percent taxes will be owed. If so, the double taxation of retirement funds by the estate and on the individual recipient's tax return can leave as little as 25 percent to 30 percent of the funds for loved ones.

Further, the after-death double taxation makes these assets the ideal choice for a charitable estate gift to a favorite nonprofit organization. No estate or income taxes will be owed on your charitable gift, allowing the full gift amount to benefit the organization.

To accomplish that, simply list the nonprofit organization's legal name (check with them to be sure) on the beneficiary form and note the appropriate percentage or dollar amount.

Your financial adviser or the firm handling your retirement funds can help you in making the best choices with retirement funds.

That's good planning.

Deborah Miller is the director of planned giving for the West Virginia University Foundation.

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