With final holiday preparations looming, the last thing anyone wants to think about is next April's tax bill. But if you're over 70-and-a-half and have any tax-deferred retirement accounts (like an IRA), you'd better put down the wrapping paper and listen up: IRS rules say that, with very few exceptions, you must take required minimum distributions (RMDs) from your accounts by December 31 of each year -- and pay taxes on the amount -- or face severe financial penalties.
Now that I have your attention, here's what you need to know about mandatory IRA withdrawals:
Why are minimum distributions required? Congress devised IRAs, 401(k) plans and other tax-deferred retirement accounts to encourage people to save for their own retirement. Aside from Roth plans, people generally contribute "pretax" dollars to these accounts, which means the contributions and their investment earnings aren't taxed until withdrawn after retirement.
In exchange for allowing your account to grow tax-free for many decades, Congress also decreed that certain minimum amounts must be withdrawn -- and taxed -- each year after you reach 70-and-a-half; otherwise, people who could afford to would simply leave the money in their accounts for their heirs to inherit, thus never paying taxes on it.
Penalty. To ensure that the RMD rules are followed, unless you meet a few narrowly defined conditions, you'll have to pay an excess accumulation tax equal to 50 percent of the RMD you should have taken; plus you'll still have to take the distribution and pay regular income tax on it.
Allowable RMD exceptions. You can delay or avoid paying an RMD in certain cases, including:
- If you're still employed at 70-and-a-half, 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; 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.
Roth IRA conversion. Another way to avoid future RMDs is to convert regular IRAs and other tax-deferred accounts into a Roth IRA. You'll still have to pay taxes on all pretax contributions and earnings that have accrued; and, if you're over age 70-and-a-half, you must first take your minimum distribution (and pay taxes on it) before the conversion can take place. Remember: In the year you do a Roth IRA conversion, the amount gets added to your taxable income, which could impact the rest of your tax calculations.
Timing your distribution. Ordinarily, RMDs must be taken by December 31 to avoid the excess accumulation tax. However, if it's your first distribution, you're allowed to wait until April 1 the year after turning 70-and-a-half 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 both RMDs 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 isn't more than 10 years younger than you, if your spouse isn't the sole beneficiary or if 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 IRS may waive the 50-percent penalty if you can convince them 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.
- You're allowed to withdraw more than the RMD in a particular year, but be aware that 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 consult a financial planner or other tax professional.
This blog post 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 your individual financial situation.