With the end of the year approaching, it is important that those required to do so take their required minimum distribution (RMD) from their retirement accounts by December 31. This pertains to those who are 70½ or older with a retirement account such as an IRA, 401(k), 403(b) or other defined contribution retirement plan. This requirement can also pertain to the beneficiaries of an inherited IRA or 401(k) under certain circumstances, even if they are younger than age 59½.
Here are a few things you need to know about required minimum distributions:
For those who are aged 70½ or older, there is a required minimum distribution each year from your retirement accounts that is based upon your age and the balance in the account(s) as of December 31 of the prior calendar year. In other words the RMD for 2016 is based upon your age at your birthday in 2016 and the account balance(s) as of December 31, 2015.
The RMD will be fully taxable to you at your ordinary income tax rate; there are no preferential rates for capital gains.
A failure to take all or part of the RMD can result in a steep 50% penalty on the amount that was not taken. In addition the taxes on this amount are still due.
The First Year Exception
There is an exception that pertains to your first year RMD only. That RMD may be deferred until April 1 of the calendar year following the year you reach the age of 70½.
As an example, let’s say you turn 70½ on February 1, 2017. Your RMD for 2017 will be based upon your age in 2017 and the account balance as of December 31, 2016. You can defer taking this distribution and the tax liability until April 1, 2018 if you like.
However if you do this you will end up taking two RMDs in 2018, as your RMD for 2018 would still be due by December 31 of that year. In many cases it makes more sense not to defer taking the first year’s RMD so as to avoid the tax liability on two distributions in the same calendar year.
In some cases, however, taking both distributions in the same year may make sense. It will really depend upon your unique situation and your tax liability in either of the two years.
If you have multiple retirement accounts, you’ll likely receive a separate RMD notice for each account. This can get confusing if these accounts are with multiple custodians. In the case of traditional IRA accounts, the total of your required minimum distributions is what counts. You can generally take the entire amount of the combined distribution from one account or from some or all of your various accounts, as long as the total amount taken is correct.
In the case of employer-sponsored retirement accounts such as a 401(k) or 403(b), you must take the RMD in the amount specified from each individual account.
When a younger beneficiary inherits an IRA from someone other than their spouse, they will be required to take RMDs if the decedent was already taking RMDs at the time of their death. Your RMD will be based upon your life expectancy not the decedents.
RMD notification will vary among various account custodians. Inherited IRA account owners will want to be proactive in terms of making sure they calculate their RMD and take it on time, as the same penalties mentioned above still apply.
The first RMD from an inherited IRA must be taken by December 31 of the year following the year of the original account owner’s death.
Roth IRAs and Roth 401(k)s
Roth IRAs are not subject to RMDs during the owner’s lifetime, but upon the owner’s death, RMDs do come into play.
Roth 401(k)s are subject to an RMD, but this can be avoided by rolling the account to a Roth IRA.
The 401(k) Exception
If you are working at age 70½ and are not a 5% or greater owner of the firm, you are not required to take an RMD from your employer’s 401(k) or similar defined contribution retirement plan. This is not an automatic exemption; your employer must elect to offer employees this option. So it is wise to consult with your plan’s administrator if you are in this position.
Qualified Charitable Distribution
Account owners who are at least 70½ are allowed to make a Qualified Charitable Distribution (QCD) from their IRA account.
A QCD allows the account holder to exclude up to $100,000 from their gross income for donations paid directly to a qualified charitable institution. For married couples there is an exclusion of up to $100,000 for each spouse, based upon their respective distributions.
The QCD is not eligible for a charitable tax deduction on top of being excluded from gross income.
Please note: as of the writing of this article, Congress has not extended this option. In past years this provision has been added very late in the year, so if you are interested, please monitor this situation.
For those who are charitably inclined and can afford to do this, the potential advantage lies in the reduction of your adjusted gross income (AGI), which can work in your favor for things like the cost of Medicare for the following year. It is best to consult with your tax or financial advisor to see if this is a good strategy for you, should Congress reinstate this option.
Strategies to Minimize Your RMD
Converting a traditional IRA account to a Roth IRA. — Roth IRAs are not subject to RMDs while the owner is alive. The tradeoff is that current-year income taxes will have to be paid in the year the conversion is done.
This strategy might be used for someone who is retiring in their 60s during years in which their income is lower than normal, or in years where a partial conversion can be used to the extent that it will ‘fill up’ their current income tax bracket.
Contribute to a Roth 401(k) while working. — Directing at least a portion of your 401(k) contribution to a Roth 401(k) if available in your company’s plan allows you to diversify your tax exposure during retirement. Though you may not be thinking about RMDs while you’re still working, planning ahead helps reduce your RMDs and tax liabilities down the road.
Reverse IRA rollovers if you are working at age 70½. — As long as the money in the IRA account was originally made with pretax money, you can roll the money out of the IRA and into your company’s 401(k) plan if they allow such transfers. According to the Profit Sharing Council of America about 70% or all employer plans allow this.
This strategy will help reduce RMDs if you are working at age 70½. You will ultimately need to take RMDs on this money once you are no longer working, but the opportunity to save some current income taxes allows your retirement nest egg the opportunity to grow for a few extra years.
Additionally the reverse rollover strategy can be a way to enable additional Roth conversions with remaining IRA money, and its use is not limited to reducing RMDs.
Required minimum distributions are a fact of life if you have money in an IRA or defined contribution retirement plan via an employer. Understanding the rules and ways to minimize your RMDs can help you in your retirement income planning.