Required Minimum Distributions: When Uncle Sam “makes” you take $ out of savings
Posted in: Retirement Planning
Published: August 28, 2017
You’ve been putting money away in your IRA for much of your life to have some measure of economic security in your senior years (and to reduce your taxable income in boon years). And through some mixture of discipline, good fortune and wits you find that don’t have to use your IRA savings the moment they become available to you at age 59½. Good for you. Keep in mind, upon reaching age 70½ you must completely change your mindset because the U.S. Government requires you to start withdrawing money. It’s called Required Minimum Distributions (RMDs).
If you’re like many of our clients, you’ll have an initial reaction of “What?!?! That’s my money!” At first, it may feel like a tax on getting old, but it’s not. RMDs are just another component to be considered as you plan for the decumulation, as opposed to the accumulation, part of life. Let’s walk through the what, why, when, and how much of Required Minimum Distributions.
What are Required Minimum Distributions?
The IRS requires that you start taking withdrawals from your qualified retirement accounts (non-Roth IRA accounts, 401(k)s, 457 plans and other tax-deferred retirement savings plans like a TSP, 403(b), TSA, SEP, or SIMPLE) once you reach age 70½. Note that RMDs are not required for Roth IRAs if you are the owner of the account, but inherited Roth IRAs are subject to RMDs, and Roth 401(k)s are also subject to RMDs. To avoid the RMD on a Roth 401(k) upon retirement you can rollover that portion to a Roth IRA.
Why do I have to start withdrawing RMDs at 70½?
It’s part of the social contract the government made with America. During your accumulation years, you are allowed to keep money from the country’s collective income (a.k.a. “taxes”) by investing it in your retirement accounts before paying taxes on it. Now that you’re 70 ½, you are required to “cash out” slowly over a time-period consistent with an optimistic estimate of your life expectancy. After years of waiting, the IRS is eager to collect the taxes you’ve deferred on these contributions.
It was a good deal for you to defer the taxes all these years, and, you may even be taxed at a lower tax rate in retirement than the rate you would have paid had you paid taxes in the years you earned the money. The idea is that a lower tax rate applies in retirement because your total income in retirement is less, typically, than when you were working. However, if you are a good saver and have a lot of money in retirement accounts, you may be surprised to find that because of all the extra taxable income from your required distributions, a pretty high tax rate applies after you are over 70 ½. With planning, you may find strategies to start taking IRA money out early to help mitigate this.
When do I have to start making RMDs?
You must take your first RMD by April 1 of the year following the calendar year in which you turn 70½. But after that, you can wait until December 31 of each year to disburse the money. It’s your call when and how you’d like to take the payments: monthly, quarterly, or annually. You’ll pay the same amount of income tax no matter what the method of distribution.
How much do I have to take out of my tax-deferred accounts?
The amount of your required distribution is based on your prior year’s December 31 account balance, and a divisor, based on your age. Your age, for these purposes, is your age at your birthday in the year of your distribution. So if you are taking a distribution in 2017, use the age that you become on your birthday that occurs in 2017.
The IRS lists the divisor in a series of published tables. The right table to use depends on your situation. Most people will use the worksheet called Table III ( (Uniform Lifetime). If you have a spouse ten years or more younger than you, and they are the sole beneficiary of your IRA, then you use a worksheet called Table II to determine how much to take out.
Here’s an example. Rick is retired and turned 70½ in July 2017. His combined IRA and 401(k) balance on December 31, 2016, was $350,000. For Rick, the “distribution period,” the government’s deliberately optimistically-weighted estimate of how many more years he’ll live, is 27.4. Rick takes the year-end balance of $350,000 and divides it by 27.4 to calculate how much he has to take out. This means Rick will have to withdraw $12,773.72 and pay taxes on that amount. The distribution period decreases every subsequent year because his life timeline decreases. When Rick is 88 years old, for example, he will divide his retirement account balance by 12.7 to determine how much to withdraw (7.9 percent).
Five RMD Best Practices
It’s usually most tax-efficient to take your first RMD in the year you reach 70½, and not wait until April 1 of the year after you reach 70½. Because if you wait and take two distributions in that second year, your taxable income most likely will be higher in that year than if you take distributions in two separate years. You can calculate the taxes doing it either way and then take the option that will result in the least taxes over those two years. With the hundreds of retirees we have worked with, we have seen very few cases where it made sense to delay the first RMD until after April 1 of the year after someone reaches 70½.
You do not have to take a cash distribution. If you don’t need the RMD to spend, you can transfer shares of investments out of the IRA into a brokerage account. For example, if you were required to take $13,000 out, you could transfer out 650 shares of a mutual fund that traded at $20 or more per share. This way you have no trading costs and the funds remain invested. At the end of the year, your IRA custodian will send you a 1099R which reports the amount of the taxable distribution.
Don’t procrastinate taking your RMD withdrawals. If you miss the December 31 deadline, you can be forced to pay a whopping 50 percent tax penalty on the amounts that were not withdrawn in time.
If you would like to avoid paying taxes on your RMD withdrawals, you don’t need the cash, and you want to be charitable, then direct your RMD to a charity. It will not be reported as taxable income on your tax return. This was a temporary provision in the tax code, called a Qualified Charitable Distribution, and it became a permanent option in 2016.
An exception is made for RMDs on your 401(k) if you are still working. If you are working after age 70½ and you are not a 5% or more owner of the business, then you can delay distributions from your 401(k) at the company you work at until April 1 of the year after you retire. (If you have other IRA accounts the RMDs are still required on those.)
The various scenarios regarding RMDs can be confusing. For example, as mentioned, you are not required to take RMDs from your own Roth IRA, but you are required to take them from Roth 401(k)s and inherited Roth IRAs. That means when your children inherit your Roth IRA they can’t let the funds grow tax-free forever – they have to start taking a specified amount out each year.
Smart planning that includes looking at all the required distribution rules can help you find ways to lower the tax liability during your retirement years.
This article does not cover all of the rules and tax implications. You’ll find additional information about RMDs on the Required Minimum Distribution page of the IRS website.