Understanding the basics of Required Minimum Distributions (RMDs)
Written by: Drew Kellerman
What do you remember most vividly about the 1970’s? I will hazard a guess that it wasn’t the creation of Individual Retirement Accounts (IRAs) and the birth of employer-sponsored, defined contribution plans - such as the 401(k) and 403(b). And yet, compared to most relics of the ‘70s, these “tax-qualified” retirement savings accounts are hugely important to today’s retiring Baby Boomers.
Just as with ladies’ knee-high boots in the 1970’s, you can choose from a wide variety of “tax-qualified” retirement savings accounts. These include Traditional, Simple and SEP IRAs, 401(k)’s, 403(b)’s, 457 Plans, and Profit Sharing Plans, among others. (We shall discuss Roth IRAs - a 1990’s creation - in a future newsletter).
In classic government fashion, each of these accounts has its own set of complicated rules, requirements and restrictions. However, they all have a few common characteristics. Each plan:
1) Allows most savers to make pre-tax contributions, reducing tax bills during the working years,
2) Defers taxes on the growth, allowing for maximum compounding opportunities, and
3) Requires the account owner to start withdrawing their savings in their seventh decade.
Because of the tax advantages (points 1 and 2 above), many people use these accounts to save for retirement. However, tax-deferred does not necessarily mean tax-free. Our clients are often startled to learn that all their withdrawals - known as “distributions” - are usually taxable as ordinary income.[i] Equally surprising for many is the fact that you cannot leave your tax-deferred money in these accounts indefinitely.
This brings us to Required Minimum Distributions (RMDs). RMDs are just what they sound like; a minimum amount you must withdraw from your account every year once you attain a certain age.[ii] The rules governing RMDs can be complex and bewildering. Breaking the rules, even inadvertently, can result in eye-watering penalties. To help you avoid these, let’s review some of the basics of RMDs.
When must I take my RMDs?
Your first RMD must be withdrawn by April 1st in the year that follows the year you attain age 70 ½. Every year thereafter, you must take your annual RMD no later than December 31st. For example, let’s say you attained age 70 ½ in October of 2017. You could take all or part of your first RMD by the end of this year, but you have the option of waiting until April 1, 2018.[iii] This three-month extension only applies to the first annual distribution.
It’s important to note that, should you wait until the following year to take your first distribution, you will need to take your second year’s RMD in the same calendar year as the first. Taking two RMDs in the same calendar year could potentially increase your taxable income for that year; in some cases, significantly.
How do I calculate my RMD amount?
They are called Required Minimum Distributions, because you must withdraw a minimum percentage of the account’s value each year. This percentage starts at 3.65% and gradually increases each year for the remainder of your life. (You can always withdraw more that the minimum required.)
You begin the RMD calculation by identifying the fair market value of the account on December 31st of the previous year. You can find this value on your account’s year-end statement. You may also receive Form 5498 at the beginning of each year, showing you the account value on the last day of the previous year.
You then apply the “distribution period” divisor for your attained age as shown in the IRS Uniform Lifetime Table.[iv] This divisor decreases every year which increases the percentage you must take from your account annually. The best way to show you how this works is with an example.
(The following example assumes your spouse is the sole beneficiary and NOT more than 10 years younger than you are. If that were the case, you would use a different table. You’d use a third table for an IRA you inherited.)
Let’s assume you own a Traditional IRA and attained age 70 ½ in October 2017. You decide to withdraw all your first RMD this calendar year. So far in 2017, you’ve withdrawn $10,000 from this account. You want to know how much more you need to withdraw to satisfy your first RMD.[v]
- Your IRA’s 2016 year-end statement (or Form 5498) shows that the account’s fair market value on 12/31/2016 was $500,000.
- Next, you look up the divisor for your age. As you attained 70 ½ this year, the divisor is 27.4.
- So, you divide $500,000 by 27.4.
- Your RMD amount for this year: $18,248.18
- Now, subtract the $10,000 you have already withdrawn from $18,248.18
- The net amount you will need to withdraw to satisfy your 2017 RMD is $8,248.18
Do I need to withdraw an RMD from each account?
You are required to calculate the RMD for each account separately. However, if you have more than one IRA, the IRS lets you combine the total RMD due and make the withdraw from either account, or both. The same rules apply to 403(b) plans. For all other account types, you’ll need to withdraw the RMD from each, separately.
For example, let’s say you have a 401(k) plan and two Traditional IRAs. First, you will need to calculate the RMD for all three of these accounts separately. You then must withdraw the RMD from the 401(k) from the 401(k), but can combine the IRA RMDs and make the aggregate withdrawal from one IRA, if you so choose.
If you have multiple plan types, this can become quite tedious and time consuming. However, once retired, you can always roll employer-sponsored plans into one or more IRAs. This is not a taxable event, if done correctly, and simplifies your future RMD process (and perhaps your retirement income planning).
What happens if I miss the deadline for my RMD?
If you miss the December 31st deadline (April 1st for the first RMD) you may face a 50% excise tax on the missed distribution amount. But first, you’ll pay federal taxes on the entire amount. For example, let’s say you are in the 25% tax bracket and you miss a $10,000 RMD:
- First, the IRS would tax the full $10,000 at 25%. This generates $2,500 of federal income tax.
- Then, they can levy a 50% excise tax on the full amount ($10,000), resulting in a $5,000 penalty.
- Add the tax to the penalty. The result? The IRS could keep as much as $7,500 of your $10,000! [vi]
This is among the more severe penalties in the US tax code. You can request relief for a missed RMD using IRS Form 5329 and an attached letter, if it was a “reasonable error and you are taking reasonable steps to remedy the error”. Even so, it’s probably wise to avoid this situation. And, don’t procrastinate. Taking a distribution from a tax-qualified account can take a week or more, so do not wait until you are up against the deadline.
What else should I know about RMDs?
Here are a few more bits of knowledge that might be helpful:
1) You cannot make contributions to your tax-deferred accounts once you begin taking RMDs.
2) A distribution that exceeds the RMD amount cannot be applied to the following year’s RMD.
3) You cannot roll an RMD into another tax-deferred account.
4) If you continue working past age 70.5 and have an active, employer-sponsored plan at your current job, you can defer your RMDs from that account until you retire. However, you must begin taking RMDs from all IRAs and all other tax-deferred accounts.
5) If you are charitably inclined, you can gift to qualified charities directly from your IRA, once age 70.5. This satisfies part or all your RMD in the year you make this “Qualifying Charitable Contribution”, reducing your gross income. This may lower your income tax burden. There are many rules governing this (naturally), so please check with you tax advisor to see if this giving strategy is right for you.
As always, we are here to help you with your distribution and retirement income planning. Just give us a call!