RMD Time: Handling Retirement Account Distributions

Anyone who owns a tax-advantaged retirement account such as a 401(k) or individual retirement account (IRA) — that’s 63% of (or 77.5 million) American households as of 2014, according to the Investment Company Institute — would be well-served to familiarize themselves with required minimum distributions, or RMDs, and the sometimes complex rules that govern them.

“RMDs aren’t that tricky,” says certified financial planner Andrew Weckbach, founder of Scaling Independence in St. Louis, MO., “but there are wrinkles you need to be aware of.”

What is a Required Minimum Distribution?

An RMD is the minimum amount the owner of an IRA or retirement plan must withdraw from their account each year once they reach age 70½, as specified by the Internal Revenue Service. RMDs apply to people who own traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans 403(b) plans, 457(b) plans, profit sharing plans, and other defined contribution plans.

RMDs from an IRA must be taken by April 1 of the year following the calendar year in which the account owner reaches age 70½. RMDs from 401(k), profit-sharing, 403(b) and other defined contribution plans generally must be taken by April 1 following the LATER OF the calendar year in which the account owner reaches age 70½ OR retires. RMDs then must be made by December 31 of each subsequent year. Withdrawals typically are considered taxable income except for any part that was taxed before (the basis). Delaying the first distribution into the second year doubles up the required distribution for that year and increases taxes for that year, which may not be a desirable result.

People who own multiple IRAs may choose to take their RMD for a given year from only one account, or they may take distributions from multiple accounts to meet the requirement. The former can make sense, Weckbach notes, when one of their multiple accounts includes an illiquid investment (such as a stock position in a small company) that’s not easily sold in order to raise funds for an RMD.

The RMD amount is calculated by dividing the amount in the account as of the end of the immediately preceding calendar year by a life-expectancy-based distribution period specified in the IRS’s “Uniform Lifetime Table.”

The IRS offers an overview of RMD rules on its website at www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Required-Minimum-Distributions.

Failing to follow those rules can be costly. Account owners who do not take any required distributions, or take distributions below the required amount, may have to pay a 50% excise tax on the amount not distributed as required. On the other hand, account holders may withdraw more than the RMD amount without penalty.

Roth IRAs

The above rules generally do not apply to Roth IRAs. The amount you invest in a Roth IRA (the basis) can be withdrawn anytime penalty- and tax-free after five years, and there are no RMDs on Roth IRAs held by the original owner. For more about IRS rules for Roth IRAs, visit http://www.irs.gov/Retirement-Plans/Roth-IRAs.

Before RMD time rolls around, IRA owners can begin taking penalty-free withdrawals at age 59½. Taking those withdrawals makes sense in certain situations, such as when the goal is to minimize RMD amounts — and the associated income tax burden — when the account holder hits age 70½. The goal, says Weckbach, is to manage income and retirement account withdrawals in order to avoid income spikes (and thus, income tax spikes) that may result from a large RMD in a given tax year. Thus, starting withdrawals before age 70½ can be an effective way to reduce income tax exposure.

Distributions taken from traditional IRAs prior to age 59½ are subject to a 10% penalty and are taxed as ordinary income, with several notable exceptions. IRS rules allow penalty-free (though not income-tax-free) early withdrawals from an IRA before age 59½ to cover such things as higher education and medical expenses, a first-time home purchase and health insurance if you're unemployed. Making early withdrawals for any reason “isn’t ideal,” says Weckbach, and should be viewed more as a last resort due to the damage they can inflict upon a retirement nest egg. Stay informed on the top mistakes you can make which affect your retirement: 8 Major Retirement Blunders

Some of the RMD wrinkles to which Weckbach refers pertain to inherited IRAs — retirement accounts that pass into the hands of a beneficiary following the death of the original account owner. Generally, a person who inherits an IRA from a person age 70½ or older who had been required to take RMDs must take the RMD the deceased account owner would have received. Then, in the year following the owner’s death, the RMD is calculated using the beneficiary’s age and life expectancy.

However, a person who inherits an IRA from a spouse (and is the sole beneficiary on the account) has several choices:

• They can avoid the beneficiary RMD by electing to treat the IRA as their own;
• They can base RMDs on their own current age;
• They can base RMDs on the decedent’s age at death, reducing the distribution period by one each year; or
• They can withdraw the entire account balance by the end of the fifth year following the account owner’s death, if the account owner died before the required beginning date.

If the account owner died before the required beginning date, the surviving spouse can wait until the owner would have turned 70½ to begin receiving RMDs.

Likewise, non-spouse individual beneficiaries can withdraw the entire account balance by the end of the fifth year following the account owner’s death, if the account owner died before the required beginning date, or calculate RMDs using the distribution period from the IRS’s Single Life Table.

Given the potential financial ramifications of these choices, it makes sense to consult a financial professional for advice and guidance on RMDs. Visit the Financial Planning Association’s national database at www.PlannerSearch.org to find a Certified Financial Planner™ (CFP®) professional in your area.

Were these tips useful? Check out our downloadable retirement brochure: Planning for the Stages of Retirement