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for Roth plans), which means the money and its investment earnings are not subject to income tax until years later when withdrawn after retirement.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 That's why Congress decreed that minimum amounts must be withdrawn -- and taxed -- each year after you reach 70 ½.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:
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:
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.
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