As people near age 70 1/2, they’re often surprised to discover that they’ll generally be required to withdraw a specific minimum amount from their retirement accounts each year, whether they need the cash or not. The required minimum distribution (RMD) rules are complicated and can result in significant tax obligations. Here’s some guidance to help retirees preserve their assets and minimize costly mistakes for failure to comply with these rules.
The rules for required minimum distributions (RMDs) can be bewildering, frustrating and potentially expensive to retirement savers and their beneficiaries.
Avoid the Year-End Crush
Taxpayers subject to required minimum distributions (RMDs) have until December to calculate and schedule RMDs from qualified plans and IRAs. It’s not unusual for people to wait until the last moment to take RMDs. So long as the proper RMD is taken prior to the end of the year, you’re in compliance with the rules.
However, to minimize the possibility of error by missing the deadline, it may be safer to take your RMDs in advance of December 31. This will give you plenty of time to make any necessary corrections before the end of the year.
And taking — or not taking — RMDs can have a substantial impact on your tax liability. Distributions generally will be taxable at your ordinary-income rate (not your lower long-term capital gains rate) unless they’re from a Roth account. And the penalty for not taking your full RMD on time is severe: 50% of the amount you should have withdrawn but didn’t.
Here are the answers to 20 common questions to help you navigate the mandatory distribution rules and minimize any negative tax consequences.
- What’s an RMD?
An RMD is the amount you’re legally required to withdraw from your qualified retirement plans and IRAs after reaching age 70 1/2. Essentially, the tax law requires you to tap into your retirement assets — and begin paying taxes on them — whether you want to or not.
- Which Plans Do the RMD Rules Apply To?
The RMD rules, also known as the mandatory distribution rules, apply to all employer-sponsored retirement plans, including:
- 401(k) plans
- 403(b) plans
- 457(b) plans
- Profit sharing plans, and
- Other defined contribution plans.
Slightly different rules may apply to pre-1987 contributions to a 403(b) plan. The rules also cover traditional IRAs and IRA-based plans, such as SEPs, SARSEPs and SIMPLE-IRAs. But there are exceptions in certain, limited circumstances.
- Do the RMD Rules Apply to Roth Accounts?
The RMD rules also apply to Roth 401(k) accounts. However, they don’t apply to Roth IRAs while the original owner is alive. So one way to avoid RMDs on your Roth 401(k)s is to roll over the account assets to a Roth IRA.
After your death, however, beneficiaries of your Roth IRA must take RMDs under the same rules that apply to traditional IRAs. As it is a Roth IRA, the distributions are tax-free, however.
- When Must I Start Taking RMDs?
The required beginning date for RMDs is generally April 1 of the year after the year in which you turn age 70 1/2. For example, if you turn 70 on June 1, 2015, you must begin taking RMDs no later than April 1, 2016. The first year is the only year you can take an RMD after the close of the year for which it applies.
- When Must I Take RMDs in Succeeding Years?
The deadline for taking subsequent RMDs is December 31 of the year for which the RMD applies. Therefore, if you turn 70 1/2 in 2015, you must take your RMD for the 2016 tax year by December 31, 2016, in addition to taking your 2015 RMD by April 18, 2016. To reduce overall tax liability, you might take the first RMD in 2015 instead of taking two RMDs in 2016.
- How Do I Calculate the Annual RMD?
Generally, all you have to do is divide the balance in the plan or IRA on December 31 of the prior year by the appropriate life expectancy factor. The IRS provides three life expectancy tables for taxpayers to use to calculate RMDs:
- Joint Life and Last Survivor Expectancy Table. This table applies if the sole beneficiary of the account is your spouse and he or she is more than 10 years younger than you,
- Uniform Lifetime Table. This table applies if your spouse isn’t your sole beneficiary or your spouse isn’t more than 10 years younger than you, and
- Single Life Expectancy Table. This table applies if you’re the beneficiary of the account.
To illustrate, suppose you’re a single 80-year-old with an account balance of $100,000 at the end of the previous year. Using the Uniform Lifetime Table, the distribution period for an unmarried, 80-year-old account owner is 18.7. Thus, you would divide $100,000 by 18.7, resulting in an RMD of $5,347.59.
- Can I Withdraw More Than the Required Amount?
Yes, there’s no restriction against excess distributions. You can take out as much as you want as long as you satisfy the minimum standard.
- Can I Apply an Excess RMD to a Future Year?
No, an RMD is calculated based on the account balance and life expectancy factor for that particular year.
- Must I Take RMDs from All Qualified Plans and IRAs?
Although you must calculate the RMD separately for each IRA you own, you can withdraw the total amount from just one IRA or any combination of IRAs that you choose. The same rule applies to 403(b) plans. However, for all other qualified plans, the RMD must be taken separately from each plan account.
- Will My Plan or IRA Administrator Ensure My RMD Is Made on Time?
Although a plan or IRA administrator may provide the information or do the calculation for you, it’s ultimately your responsibility to take the RMD for the applicable tax year.
- How Do I Estimate the RMD Penalty?
The penalty is equal to 50% of the amount that should have been withdrawn, reduced by any amount you withdrew for the year. For example, if you were required to withdraw $10,000 and took out only $2,500, the penalty is $3,750 (50% of $7,500). In addition, you must still take the RMD. The penalty is in addition to any other tax you owe on the RMD. Penalties are the responsibility of the account owner, not the plan.
- How Do I Estimate the Income Tax on an RMD?
Generally, distributions are taxed at ordinary income rates. But any amount attributable to a return of basis from a traditional or Roth account or a qualified distribution from a Roth account is tax free.
- Are There Any Exceptions to the RMD Penalty?
The penalty may be waived if you can show that the shortfall was due to reasonable error and you’re taking steps to remedy it. To qualify for this relief, file Form 5329 and attach a letter of explanation. Your tax adviser can help draft this letter to demonstrate why your situation qualifies for an exception.
- Are RMDs Subject to the NIIT?
Distributions from qualified retirement plans aren’t included in net investment income for purposes of the 3.8% net investment income tax (NIIT). However, RMDs will drive up your modified adjusted gross income, which could trigger or increase NIIT liability on your net investment income.
- Can I Still Contribute to a Qualified Plan or IRA if I Take RMDs?
RMDs don’t affect your eligibility for retirement plan contributions. So, if an 80-year-old employee is still working and participating in a qualified plan, his or her employer must make contributions on the individual’s behalf and give the employee the option to continue making salary deferrals if the plan permits them. Otherwise, the employer’s plan could lose its qualified status.
- Do I Have to Take RMDs If I’m Still Working?
Generally, you must take RMDs from all qualified plans and IRAs. However, you don’t have to withdraw an RMD from your employer’s qualified plan if you still work full-time for the employer and don’t own 5% or more of the company. There’s no similar exception for IRAs.
- Can I Roll Over an RMD to another IRA or Tax-Deferred Retirement Plan?
No, rollovers are strictly prohibited. Allowing retirees to roll over RMDs to another retirement account would defeat the intention of the mandatory distribution rules.
- Can I Donate RMDs to Charities?
In the past, you could transfer up to $100,000 directly from an IRA to a charity without paying tax on the distribution. But this tax law provision expired December 31, 2014. Under the current rules, if you wish to donate your RMD to a charity, you’re taxed on the distribution at ordinary income tax rates, and then you may deduct it as a charitable contribution.
There’s been some discussion in Congress lately about possibly reinstating the rule. If you’re interested in donating your RMD to charity, contact your tax adviser about any recent developments later this fall.
- What Happens If I Die Before RMDs Have Begun?
No distribution is required for the year of death. For subsequent years, RMDs must be taken from inherited accounts. A spousal beneficiary has greater flexibility than a non-spousal beneficiary, including being able to treat the account as his or her own.
Generally, the entire amount of the owner’s benefit must be distributed to the beneficiary who is an individual either (1) within five years of the owner’s death, or (2) over the life of the beneficiary starting no later than one year following the owner’s death.
- What Happens If I Die After RMDs Have Begun?
The beneficiaries of the accounts must continue to take RMDs under a complex set of rules. Again, spousal beneficiaries have greater flexibility than non-spousal beneficiaries.
Important Note: The beneficiary of a deceased owner of a retirement account can be subject to tax penalties if he or she fails to comply with the post-death distribution rules. If a retirement account owner dies mid-year, the beneficiary may be unaware that the owner has passed away before taking his or her full RMD for the year. Other complex rules may apply if there are multiple non-spousal beneficiaries or if a trust is the beneficiary of a retirement account. Contact your tax professional for guidance if you inherit an IRA or other retirement account assets.
For More Detailed Answers
The mandatory distribution rules for qualified retirement plans and IRAs are complex and may change under Congressional tax reform measures. In the meantime, you can minimize your tax liabilities and preserve more assets for your heirs with careful planning. Contact your tax professional to customize the optimal plan based on your individual retirement and estate planning goals.