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Deadline Approaches for Mandatory IRA Withdrawals

Posted: 11/30/11 03:37 PM ET

Reaching your 70th birthday is a momentous cause for celebration. But thanks to a quirk in our tax code, a potentially more important milestone arrives six months later. That's because IRS rules say that, with a few exceptions, you must begin taking required minimum distributions (RMDs) from any IRAs, 401(k) plans and other tax-deferred retirement accounts you own beginning in the year you reach age 70 ½ -- and pay income taxes on the amount.

Failure to make these mandatory withdrawals by December 31 each year can result in severe penalties, so if you or someone you know are approaching or already at that threshold, read on:

Why have required minimum distributions? Congress devised IRAs, 401(k) plans and other tax-deferred retirement accounts as a way to encourage people to save for their own retirement. You generally contribute "pretax" dollars to these accounts (except for Roth plans), which means the money and its investment earnings are not subject to income tax until years later when withdrawn after retirement.

People who can afford to would probably opt to leave the money in their accounts for heirs to inherit -- thereby avoiding those long-deferred taxes. That's why Congress decreed that minimum amounts must be withdrawn -- and taxed -- each year after you reach 70 ½. To give the regulation teeth, it specifies that unless you meet certain narrow conditions, you'll have to pay an excess accumulation tax equal to 50 percent of the RMD you should have taken -- in addition to still having to take the distribution and pay regular income tax on it.

Exceptions to the rule. There are a few cases where you can delay or avoid paying an RMD:

  • If you're still employed at 70 ½, you may delay starting RMDs from your 401(k) or other work-based account until you actually retire, without penalty; however, regular IRAs are still subject to the rule, regardless of work status.

  • Roth IRAs are exempt from the RMD rule; curiously, however, Roth 401(k) plans are not.

  • You can also transfer up to $100,000 directly from your IRA to an IRS-approved charity. Although the RMD itself isn't tax-deductible, it won't be included in your taxable income, which could reduce taxes on your Social Security benefits and make you eligible for tax breaks tied to Adjusted Gross Income (AGI). It also lowers your overall IRA balance, thus reducing the size of future RMDs.

Another way to circumvent the RMD is to convert all regular IRAs and other tax-deferred accounts into a Roth IRA. You'll still have to pay taxes on all pretax contributions and earnings; and, if you're over age 70 ½, you must first take your minimum distribution (and pay taxes on it) before the conversion can take place.

Timing your distribution. Ordinarily, RMDs must be taken by December 31 to avoid the penalty. However, if it's your first distribution you're allowed to wait until April 1 the year after turning 70 ½ if you wish -- although you're still required to take a second distribution by December 31 of that same calendar year. The potential downside is that depending on the size of your accounts, taking your first and second RMD in the same year could bump you into a higher tax bracket.

How RMDs are calculated. Generally, you must calculate an RMD for each IRA or other tax-deferred retirement account you own by dividing its balance at the end of the previous year by a life expectancy factor found in one of the three tables in Appendix C of IRS Publication 590:

  • Use the Uniform Lifetime Table if your spouse is not more than 10 years younger than you, your spouse is not the sole beneficiary or you're unmarried.

  • Use the Joint and Last Survivor Table when your spouse is the sole beneficiary and he/she is more than 10 years younger than you.

  • The Single Life Expectancy Table is for beneficiaries of accounts whose owner has died.

Although you must calculate the RMD separately for each IRA you own, you may withdraw the combined amount of all RMDs from one or more of them. The same goes for owners of one or more 403(b) accounts. However, RMDs required from other types of retirement plans, such as 401(k) and 457(b) plans, must be taken separately from each account.

Other rules and tips

  • The 50 percent penalty may be waived if you can convince the IRS that the shortfall was due to reasonable error and that you're taking steps to remedy the situation. To qualify for this relief, you must file IRS Form 5329 and attach a letter of explanation. See the Form 5329 Instructions for further information.

  • You can always withdraw more than the RMD in a particular year, but you cannot carry over the surplus to use against future years' RMDs.

  • You can take your RMD in monthly, quarterly or other installments, as long as you take the full amount by year's end.

  • Even though you must take your RMD and pay the taxes, you needn't spend the money; you may redeposit any or all of it into another nonretirement savings or investment account.


Because calculating required minimum distributions can be fairly complicated, especially the first time out, you may want to give yourself the gift of a session with a financial planner for your 70th birthday -- or sooner, if possible. For tips on choosing a financial planner, see my previous blog, Financial Planners Not Just for the Wealthy.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

 

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