As we approach the end of the year, it’s time to start getting your retirement accounts in order. There are certain things you must do, depending on your age and the type of account(s) you have. Today, we are going to look at required minimum distributions or RMD. Taking RMDs must be done by anyone who is at least age 70 1/2. Again, this depends on your retirement accounts. Therefore, if you turned 70 1/2 this year (or have already reached that age), this article is for you. We will explain RMDs, how to calculate them and even ways to avoid them.
What is an RMD?
As stated on the IRS website, an RMD is “the minimum amount you must withdraw from your account each year.” Once you reach the magical age of 70 1/2, you must start taking RMDs. Traditional retirement plans are funded with pre-tax money. Taxes are tax-deferred until you start taking distributions during retirement. The RMD ensures you don’t have an unlimited, tax-advantaged account. The IRS felt 70 1/2 was the right age to make withdrawals mandatory. Although, new laws may bump that number to 72. This would give everyone 18 more months of deferring taxes (which is a good thing).
You may ask yourself, I’m retired, why wouldn’t I take funds from my retirement account? Believe it or not, there are people who don’t need their retirement funds to live off. They’ll use the account as a way to lower their annual tax bill and then pass it on to one of their heirs. However, the IRS won’t let that money grow tax-free indefinitely. Hence, the RMD rules.
Who Must Take RMDs?
Aside of reaching the age of 70 1/2, you must have the types of plans subject to the RMD. Generally, these account for most plans. If you have a workplace 401(k) or 403(b) plan, most types of Individual Retirement Accounts (IRA) or a Solo 401(k), you must take RMDs. The one exception is the Roth IRA. However, if you have a Roth 401(k), you must take RMDs as well.
There is one other exception if you are still working. If you are currently employed and own less than 5% of the company, you do not have to start your RMDs until you leave the job. Please note that this only applies to the retirement account at your current job. For example, if you have a 401(k) from a previous employer or an IRA, you must satisfy the RMDs for those plans. The RMD is only on hold for the retirement account at your current job. For those with a Solo 401(k), you cannot avoid RMDs since you probably own more than 5% of the company.
Calculating Your RMD
There are two important factors to consider when taking your RMD: your age and your account balance. Obviously, your current age of the time of the RMD is considered. You will use the account balance(s) as of December 31 of the previous year. Using the life expectancy table provided by the IRS, you can calculate your RMD for the year. (Check out the RMD worksheets.)
Using the table, you can find your life expectancy factor. Then, you take your account balance and divided it by that number. Here’s an example: Sam is 75 years old and has a $100,000 balance in his 401(k). Looking at the table, you see 22.9 is the distribution period. $100,000 divided by 22.9 = $4,366.81. This is the amount of Sam’s RMD.
If you have multiple retirement accounts that requires taking RMDs, you must do this for each of the accounts. Now that you’ve figured out all the RMDs you must take, it’s time to distribute the funds. IRAs and 401(k) plans differ in this regard. Your IRA RMD can be taken from one or multiple IRAs. Depending on how your investments are doing in each one, it might make sense to take your entire RMD from one account. Alternatively, all things being equal, you can spread it across several IRAs.
However, 401(k) plans are different. If you have multiple 401(k)s, you must figure out the RMD for each plan and the amount must be taken from each account. If you have two 401(k) plans that each owe $2,000 in RMDs, you cannot take $4,000 from one plan. You must take the $2,000 from each plan.
Taking RMDs on an Inherited Plan
Assuming you are married, you must leave your 401(k) to your spouse. The plan can remain where it is, so long as the company allows it. You may also choose to roll the funds into an Inherited IRA. If choosing the latter, the rules will differ based on the relationship of the beneficiary to you (spouse or non-spouse).
As for IRAs, the rules are different depending on who you were to the deceased. Spouses are treated differently than non-spouses. Other entities, such as a trust, are also different. If you are a spousal beneficiary, you have essentially two options. The first one is to assume the IRA as your own. You can roll over the funds into an IRA that you control. RMDs start when you reach age 70 1/2. Your other option is to open an inherited IRA. The benefit of this is if you are under age 59 1/2. You can withdraw from the plan without paying an early withdrawal penalty. RMDs would start when your spouse would have reached 70 1/2. Obviously, if he/she was older, RMDs would need to be taken the year after your spouse passed.
If you are a non-spouse beneficiary, such as a son or sister, you have two options as well. You can choose to take RMDs based on the original owner’s age (if at least 70 1/2) or yours if he/she was not yet taking RMDs. The other option is known as the five-year rule. You must distribute all funds within five year of the owner’s death. You don’t have to withdraw anything until that time (or you can take it all if you wish). That way, it can continue to grow unhindered until you must withdraw.
Again, there are differing rules depending if you were a spouse or not. Spouses can assume the Roth IRA as his/her own. Therefore, RMDs will not come into play for you. Non-spouses, however, cannot do this. They must follow the above rules, and either start taking RMDs based on their life expectancy, or distribute the entire account within five year.
Note: New legislation may also change how inherited IRAs are treated. Stay tuned…
Roth 401(k) Workaround
Unlike a Roth IRA, you are required to take RMDs from a Roth 401(k). However, there is a way to avoid this. You can simply roll the entire balance into a Roth IRA before reaching age 70 1/2. Thus, leaving the Roth 401(k) with a zero balance and therefore no RMD will be required. Since the funds are now in the Roth IRA, they can continue to grow on a tax-free basis.
What if You Don’t Take Your RMD?
Failure to take all the necessary RMDs will lead to stiff a stiff penalty. FIFTY PERCENT is the cost of a missed RMD. You will be penalized 1/2 of the amount of the RMD that was not taken. For example, if you were supposed to withdraw $5,000 and you only took $4,000, you will be hit with a $500 penalty (50% of the missed $1,000). This penalty will continue until you remedy the situation.
The deadline, for most years, to take your RMD is December 31. It’s important that you don’t wait until the last minute to satisfy your RMD. The exception is the year you reach age 70 1/2. You have until April 1 of the following year to take your initial withdrawal. Keep in mind, if you choose to wait until the next year, you will be taking two distributions during year two. Consider the fact that distributions are treated as taxable income and will effect your tax bill.
It’s important to work with an expert when taking your RMDs (at least for the first year or two). Failure to do so appropriately will have adverse consequences. Once you are familiar with the process, you can generally do it yourself.
With the end of the year approaching, it’s important to make sure your affairs are in order. Missed distributions have the steepest penalty, so it’s the first thing you should focus on once you reach 70 1/2. Taking RMDs may not be in your best interest, however they are required for most retirement plans.