Many retirees who have low or no distribution needs struggle with the concept of required minimum distributions, or RMDs. Here is a brief primer to get you up to speed and cut through the fog.
To help us illustrate these points, let’s consider a hypothetical retiree.
As most retirement investors are aware, retirement accounts like pre-tax 401(k)s and traditional IRAs defer taxes until funds are withdrawn. The idea is to encourage you to save by sheltering contributions from tax and allowing the funds to compound free of capital gains taxes.
But Uncle Sam is a rather greedy soul. If you saved pre-tax in 401(k)s or made deductible contributions to IRAs during your working years, he’s never had a chance to earn taxes on that money. He wants you (YOU!) to withdraw money from your IRA, so it can be taxed at your ordinary income tax rate. As such, the tax code mandates you to begin withdrawing funds at age 70 ½, and whether you need the cash flow or not, you’ll have to withdraw or face a steep penalty. (Note: This doesn’t apply to Roth IRAs or Roth 401(k)s, as contributions are made to those after tax. Roth investors give Uncle Sam a cut up front.)
Did you just turn 70 ½? If so, congrats! (Or we’re sorry, whichever you prefer.) You have until April 1 of the following year to take your RMD. Each year thereafter, you will have to withdraw the money before December 31.
Jim, our hypothetical investor, was born on January 7, 1945. That means he turned 70 ½ on July 7, 2015. Jim has until April 1, 2016 to withdraw his first RMD—the one for calendar year 2015.
Now, the IRS’s generosity may seem great, but there is a point to consider: If Jim waits until April 1 to take his 2015 RMD, he will have to take 2016’s in the same year. Taking two RMDs in one calendar year will increase the tax impact. While we won’t get into what Jim and Janet should or shouldn’t do, we point it out an important piece of information those planning to wait to take their first RMD must consider. Don’t blame the fun folks at the IRS for this one—you’ve been warned.
In general, the custodian firm of your retirement account will calculate an RMD for every eligible account you have. The calculations are all based on the accounts’ value on December 31 of the preceding year. Then, the IRS employs life expectancy tables (here is a link) to generate a divisor. The idea behind this is the IRS wants you to deplete the account by the time you die.
Since Jim and Janet are only two years apart in age, they have chosen to use a table the IRS dubbed the “Uniform Lifetime” table of RMD divisors. There are many tables, and your beneficiary is a key factor determining which one you should use. Talk to your tax professional about what may be best for you. If your aim is to reduce the tax impact of RMDs—adjusting your beneficiary can help.
Here is a brief hypothetical example we’ve drawn up based on Jim’s situation and the IRS’s calculation tables.
Source: Internal Revenue Service, as of 3/21/2016. Table III – Uniform Lifetime Table.Our hypothetical retiree Jim will be required to take out $18,248.18 for his 2015 RMD.
Many times, a reason that 70 ½ year olds don’t understand the RMD rules is that they have other sources of income covering their expenses—they don’t need the RMD to fund their lifestyle. First, if this is you, kudos to you. (Second, if this is you, don’t factor RMDs into your financial plan as cash flow.) But the question remains: What will you do with the money?
You have a few options here, which will vary in attractiveness based on your situation.
Uncle Sam, as we told you earlier, is greedy. If you do not take out a sufficient amount, the IRS may hit you with a 50% excise tax on amounts not withdrawn. That hurts. If you’ve forgotten to take a withdrawal, contact a qualified tax professional immediately!
Good question. An RMD will be calculated for every account you have. You must take out the total sum, but needn’t take money from every account. If our hypothetical Jim had two IRAs valued at $250,000, Jim could withdraw $9,124.09 from each. Or any other combination so long as it totals the $18,248.18 he is required to take out by IRS rule.
The contents of this document should not be construed as tax advice. Please contact your tax professional.