The ABCs of RMDs
By Clare McNamara
Using a retirement savings vehicle such as a traditional IRA or a 401(k) can make saving and planning for retirement more effective. These accounts are tax-deferred, which helps compound the growth of your investments.
The government allows tax-deferred accounts to boost retirement saving, essentially making a deal with you to help you save for retirement. For your part, the government expects you to use that money for retirement. If you don’t, you could face tax penalties.
To make sure tax breaks meant for retirement do not carry on indefinitely, the tax law requires minimum distributions, or RMDs, beginning at age 70½.
An RMD is a partial disbursement from the retirement account each year. You can face hefty penalties if you don’t take distributions: Up to 50% of the amount you neglected to withdraw. So say you forget to take your RMD of $1,000 for one year. The Internal Revenue Service will require you to take out the $1,000 and penalize you $500 on top of it.
RMDs are also referred to as minimum required distributions or MRDs.
By April 1 of the year following the year you turn 70½, you should have taken your first RMD. For example, if your 70th birthday was May 5 2015, making you 70½ November 5 2015, you must take your first RMD by April 1, 2016. After your first RMD, you must take your distribution each year by Dec. 31.
Plan accordingly with your financial advisor. If you happen to take both your first and second RMDs in the same calendar year, you could move into a higher tax bracket. By taking that first RMD within the calendar year when you turn 70½, you could avoid moving up tax brackets.
An automated distribution can help you plan.
“IRA owners should work with an advisor to determine how and when to take their RMD,” says Isabelle Denton, an investment advisor at Landaas & Company. “Some may find they need to break it into monthly payments to help cover their household expenses while others may prefer to take it all out at a certain time of year, like during the holidays.”
If you want to take money out of a qualified retirement account before age 59½, and you don’t qualify for an exception, the IRS considers it an early withdrawal and taxes the distribution and adds on a 10% penalty.
“But after age 59½, it’s a cookie jar” says Art Rothschild, vice president and investment advisor at Landaas & Company. After 59½, he says, you still pay income tax on the money you take out, both federal and state, but without the penalty. Like a cookie jar, you do not want to let your account sit untouched, but also you don’t want to overindulge and not have enough for your retirement.
The amount of your RMD is determined by your age and the value of your account as of Dec. 31 of the prior year. The IRS provides a table that estimates your life expectancy, which is used in calculating your RMD.
Since your age and the amount in your account change each year, so will your RMD.
If your spouse is more than 10 years younger, the IRS takes into account your spouse’s possible use of your retirement account as your survivor.
Again, you can set up automated distributions to automatically calculate the RMD and distribute the correct amount monthly, quarterly or in one annual lump sum.
Make sure to include RMDs when planning the income you need in retirement, along with Social Security and pension benefits.
Some retirees find that they don’t need the RMDs to cover their living costs. For them, strategies include:
- Making an in-kind distribution – keeping the money invested but taking out enough to cover the tax on the RMD.
- Taking a qualified charitable distribution, through which you don’t have to pay income tax on the RMD. A QCD can satisfy RMD rules if you elect to donate your distribution, up to $100,000 per taxpayer, directly to a qualified charity. That is particularly helpful to taxpayers who expect to take the standard deduction. Be aware that the QCD expired Dec. 31, 2014, but Congress has a history of extending it.
Be sure to designate beneficiaries to inherit the account. Most often, the primary beneficiary is a spouse, whose options include making the account their own and determining RMDs based on their own life expectancy.
FAQs about RMDs, from the IRS
Selecting Retirement Payout Methods, from the Financial Industry Regulatory Authority
Distributions from Individual Retirement Arrangements (IRAs), from the IRS
Non-spousal beneficiaries also must take distributions from an inherited IRA.
Consult with your advisor and tax professionals about the finer details of RMDs. Just know that the required distributions are your part of a deal that allows you to accumulate retirement savings while deferring taxes. Through proper planning, you can incorporate RMDs into your retirement spending without incurring onerous tax penalties.
Clare McNamara is a summer intern at Landaas & Company. She is a senior at Marquette University majoring in finance and international business.
(initially posted Aug. 25, 2015)