Now that 2019 is winding down, it’s important to make sure your financial matters are taken care of. One of the most important ones to remember if you are at least age 70 1/2, is your required minimum distribution or RMD. This is the amount that the IRS requires you to withdraw from most retirement accounts, including Self-Directed IRAs and 401(k) plans. If this is your first or second year taking RMDs, this is something you should read. It can also be a refresher for those of you who don’t quite understand the rules.
What Is a Required Minimum Distribution?
You can find the full definition on the IRS website, but, in short, it’s “the minimum amount you must withdraw from your account each year.” Remember, this is for individual retirement savers who are at least age 70 1/2. If you are getting close to that age, you may want to learn the rules so it doesn’t come as a surprise when the time comes. The IRS has deemed this age to start collecting the taxes that have been deferred for years. Note that the SECURE Act, which may be enacted in 2020, may push the RMD age to 72. This would give you an extra 18 months to defer those taxes.
Assuming you will need your retirement funds when you hit 70, RMDs might not be a big deal for you. However, if you don’t necessarily need those funds (and wish to pass them to your heirs) you may think about converting. You can convert funds from a traditional. pre-tax account to a Roth IRA. You will pay the taxes on the conversion, but Roth IRAs are exempt from the required minimum distribution rules. The funds can then continue to grow, even after you reach age 70 1/2.
Who Must Take an RMD?
We’ve mentioned the age that distributions must start, so let’s talk about the plans that require them. Essentially, just about any retirement plan is subject to required minimum distributions, except the previously mentioned Roth IRA. Therefore, if you have a 401(k), 403(b), other defined contribution plan or any type of IRA, including SEP, SIMPLE and Self-Directed IRAs, you must take RMDs.
The only exception is if you are currently working at a job and have a retirement plan there. That plan, and only that plan, is exempt from the required minimum distribution. If you have any other plan mentioned above, you must satisfy your RMDs for them.
How to Calculate your Required Minimum Distribution
Now for the tricky part, especially if you have multiple retirement accounts – calculating your distributions. First of all, the rules are different for IRAs and 401(k) plans. The one constant is that you must calculate your RMD for each plan you own separately. The difference is where you can take your withdrawal from. If you have multiple IRAs, you may choose to spread your RMD across all/any of them, or you can choose to take your total IRA RMD from one account. However, if you have multiple 401(k) plans, you must satisfy the RMD from each account.
Here’s an example – Let’s say Jim has two IRAs and two 401(k) plans and they each are worth $100,000. Jim calculates his RMD as $5,000 for each account. He must take the $5,000 from each of his 401(k) plans. The $10,000 total RMD for his IRAs can be taken from one or both accounts. Since one of Jim’s IRA is performing better, he decided to take $2,000 from that one and $8,000 from the under-performing one.
Calculating your Required Minimum Distribution
Using the RMD worksheets found on the IRS website, you can easily calculate your RMD for each retirement account you own. Essentially, you take you account balance from December 31 of the previous year and divide that by the distribution period based on your age.
For example, Jim is 73 years old and his IRA is worth $250,000. Using the life expectancy factor found on the worksheet, you can calculate Jim’s RMD. $250,000 divided by 24.7 equals $10,121. Jim must withdraw this amount before the end of the year. Of course, you may choose to withdraw more than this amount. All distributions are treated as income and taxes will be due on the amount when you file your taxes.
Other Things to Consider
If you have inherited an IRA or 401(k), you must also think about required minimum distributions. A lot depends if you were the plan owner’s spouse or not. For 401(k) plans, if you are married, your spouse must inherit the plan unless he or she waives this right. If the plan allows it, you may choose to leave the funds there. Alternatively, you can roll the money into an Inherited IRA. And follow the upcoming rules.
If you inherit an IRA and you are the spouse, you have two options. First, you can assume the plan as your own and roll the assets into your own IRA. Distributions would start once you reach age 70 1/2. Secondly, you may choose to open an Inherited IRA. This will benefit those who are under age 59 1/2. Before that age, you would generally be imposed an early withdrawal penalty if you distribute money. However, that penalty is waived for an Inherited IRA. RMDs would start once your spouse would have reached age 70 1/2. If he or she had already reached that age, you must start withdrawing the following year. Note, if you inherit a Roth IRA and you were the spouse, you can treat it as your own and not have required minimum distributions.
Non-spouse IRA beneficiaries have different options. You can opt to start taking distributions if the owner was age 70 1/2+, or you may use your own age if he or she was not yet taking RMDs. Your option is known as the five year rule. You must withdraw all funds from the account within five years. The benefit is that you can wait until the very end to distribute the money. You can allow the funds to grow for the entire five year period before having to withdraw. Roth IRAs are treated similarly.
Qualified Charitable Distribution
If you have an IRA and do not need the funds you can donate them to a charity of your choice. You are required to take distributions, but you are not required to keep the money withdrawn. Since RMDs are treated as taxable income, any money you personally keep will be taxed. Therefore, if you do not need the money and donate it to a charity, you are off the hook as far as taxes go.
A Qualified Charitable Distribution will help keep your tax bill low and allow you to help a cause close to you. As we alluded to, this is only for IRAs. You cannot avoid the tax man with a 401(k) QCD!
Roth 401(k) Option
Unlike a Roth IRA, Roth 401(k) plans must also take required minimum distributions. However, there is a way to avoid the RMDs. All you have to do is rollover the entire account balance into a Roth IRA. Therefore, once you reach age 70 1/2, you will not be required to withdrawn money from the plan. What’s great about this, no taxes will be due on the rollover since Roth accounts are funded with after-tax income.
It is important to heed the five year rule of the Roth IRA. Withdrawals are tax-free only once the account has been open for five years and you are at least age 59 1/2. It’s good planning to fund the Roth IRA before you start rolling 401(k) funds into it.
Cash on Hand
It’s important that you have enough liquid assets, such as cash, to take your RMD. This is especially important for our Self-Directed IRA clients who invest in alternative assets. If all your funds are tied up in an investment, such as a real estate property, you cannot satisfy your RMD. You may need to sell of an entire property just to be able to take your distribution. Proper planning is needed as you start nearing the required distribution age.
Failure to Take Your RMD
As with anything involving the IRS, if you don’t follow the rules, expect to be hit with a penalty. Required minimum distributions are no different. You will be hit with a fifty (50!) percent penalty on the amount not taken. This penalty will continue until you satisfy your RMD requirement. For example, if you only withdrew $10,000 of a $25,000 RMD, you will be penalized $7,500 (which is 50% of the RMD you failed to take).
As we touched on earlier, you must take your RMDs before the end of the year. The only exception is during the year in which you turn 70 1/2. You first distribution can be pushed back until April 1 of the following year. However, you will then owe two RMDs for that year. This will increase your tax bill in the ensuing year. Therefore, if you are prepared to take your first RMD before year-end, you may be better off.
Required Minimum Distribution Conclusion
Most people will need their retirement funds later in life. Only those who have done really well may not need them. The key is to make sure you take at least the amount you are required to withdraw. If you forget to this, you will be hit with severe penalties. Afterall, the IRS wanted the taxes you have been deferring for all these years!
If you have any questions about how to calculate your required minimum distributions, please contact us @ 800.472.1043. Of course, you may want to work with a financial advisor to make sure your affairs are in order.