Update: See The SECURE Act: The New 2020 Retirement Plan Rules for updates to the timing of RMD requirements.
You may not have given it that much thought while you were socking away your retirement contributions over the years, but in every life, some rain must fall! The rain in your IRA may be that “special” time when you must start withdrawing funds from it. Many retirees taking required minimum distributions (RMDs) from their traditional IRAs may not know all of the ins and outs of exactly the right way to do it and avoid any penalties along the way if they don’t!
Making IRA RMDs: the What, When, and How
When you reach age 70½—and that’s about 3.5 million Americans right now—you need to know the ins and outs of required minimum distributions (RMDs). If your parents or grandparents are the ones moving into RMD-land, do them a favor and give them some really good advice and information about this subject ASAP.
If you’re younger, you don’t need to make any IRA withdrawals upon your retirement, so good for you. Nothing to see here.
But, when you hit the age of 70½ and you must take your RMD to live on during the year, wait until December of the required year to take the money. Ask your IRA sponsor to hold back a big chunk of it for the IRS—enough to cover your estimated tax on both the RMD and any other taxable income as well.
Although estimated tax payments are considered made when you send the checks, amounts withheld from IRA distributions are considered paid throughout the year, even if they are made in a lump sum at year-end. So, if your RMD is more than large enough to cover your tax bill, you can keep your cash safely ensconced in its tax shelter most of the year…and still avoid any underpayment penalty.
So Happy Birthday Mr. and Mrs. Retiree
If your 70th birthday falls between January 1 and June 30, you’ll turn 70½ in that same year and must take your first required distribution from your traditional IRAs. If your birthday is July 1 or later, your first RMD will come in the following year. Generally, you must take RMDs by December 31, but first-timers can wait to take their initial payout until as late as April 1 of the following year.
So if you reached 70½ in 2018, you can postpone your first withdrawal until 2019. But doing so means you’ll have to take two distributions this year. Be sure to check whether that could push you into a higher tax bracket, cause more of your Social Security benefits to be taxed, or subject you to the Medicare high-income surcharge a couple of years later.
With tax reform though, there’s a good chance delaying your first RMD has paid off handsomely if you’re now in a lower tax bracket.
Calculating the Amount of the IRA RMD
You don’t need a computer or a degree in accounting to figure out how much you must withdraw from your IRAs. First, find your 2018 year-end balance of every traditional IRA you own and add them up. Then divide the total by a factor provided by the IRS that’s based on your age and life expectancy. For most IRA owners, the divisor for the year they turn 70½ is 27.4. So, for example, if your IRAs held a total of $500,000 at the end of 2018, your RMD for 2019 is $18,248. If you don’t want to do the math, use an RMD calculator.
The good news is this: an IRA owner whose spouse is more than 10 years younger and the sole beneficiary of the account has a different, larger factor, which will lead to an even lower required payout. You’ll find the right number at the IRS website and remember, you can always take more than the minimum if you want to do it.
What About My 401(k)?
Reaching age 70½ also triggers required distributions for most 401(k) owners. But the rules aren’t exactly the same as for IRAs. First, if you have more than one workplace retirement plan, you must figure the RMD for each account (based on the same life-expectancy factor that applies to IRAs), then withdraw separate RMDs from each account. You can’t pick and choose which account to tap, as you can with IRAs. If you’re still working at 70½ (and you don’t own 5% or more of the company), you can delay your first RMD until the year you stop working.
Does the RMD Have to Be in Cash?
Most RMDs are taken in cash, but they don’t have to be. If you own stock or mutual fund shares you’d like to hold on to, for example, you can have the shares transferred to a taxable account. As long as the value of this in-kind distribution equals your RMD, you’ll be square with the IRS. You’ll owe tax on the distribution, just as if you had withdrawn cash.
Most payouts from traditional IRAs are fully taxed in the year you withdraw them. But it’s clear from the tax form that that’s not always the case. If you have ever made a non-deductible contribution to your IRA, then part of every withdrawal will be tax-free. That’s the good news. The bad news is that it’s up to you—not the IRS or the IRA sponsor—to keep proper track and to know that or not.
IRA RMD Withholding?
As a general rule, an IRA sponsor will withhold 10% of your payout as taxes to be sent to the IRS. But, unlike tax withholding on wages, this payment is completely voluntary. If you want to block withholding—or have more than 10% withheld—simply tell your IRA sponsor at the time you request the distribution. Withholding tax on your RMD may simplify your life if it permits you to avoid making quarterly estimated tax payments during the year.
The Penalties If You Mess This Up
One of our tax laws’ most draconian penalties is reserved for those who fail to take as much out of their IRAs as the RMD rules demand. The penalty is equal to 50% of the amount you failed to withdraw. It’s as though Uncle Sam were saying that if you don’t want the money he will be happy to take it off your hands. If you miss the RMD deadline though, don’t automatically send a check to the IRS. The agency can—and often does—waive the penalty for taxpayers who have a good excuse, such as getting lousy advice from a tax preparer.
Remember, the M in RMD stands for minimum. You can always take more out of your IRA than the RMD demands (although you’re probably best off leaving the money in the tax shelter until you need it). And there is no requirement that you spend the money once it comes out of the account. You have to pay tax on the distribution, yes, but you can immediately reinvest it using a taxable account.
The IRA RMD was designed to ensure that retirement funds are used for just that—retirement— rather than a tax shelter for inheritance. So make sure you prove to the IRS that you are taking distributions from your retirement funds to avoid that dreaded penalty. It just makes good sense!
Have you reached age 70½ yet? Have you considered your IRA RMD in your retirement plans?