What’s a Required Minimum Distribution?
Tax deferred retirement accounts like traditional IRAs and 401(k)s have the benefit of reducing taxable income in the year of contribution, however upon withdrawal the amount is then included into income and taxed. Traditional IRAs and 401(k)s are also known as regular or ordinary, and are not to be confused with Roth accounts, which have different rules and tax treatments.
Because the assets in a traditional account have not yet been taxed, the IRS has imposed a rule that once you reach age 70 ½ you must withdraw at least a certain calculated amount each year going forward. These are called required minimum distributions, or RMDs. Not withdrawing at least your RMD could result in a 50% excise tax, but if you simply forget once to take your RMD, don’t worry - there are avenues to do a late withdrawal and get the penalty waived by filing Form 5329.
How does this work now?
The RMD is required to be withdrawn starting with the year you reach age 70 ½, and distributed for that year by April 1 of the following year, at the latest. This does get confusing for the first RMD year, and I don’t know why they had to make it 70 ½ rather than 70…but I don’t write the laws.
Say your 70 ½ birthday is January 4th, 2020, this means 2020 is your first RMD year. So for the 2020 tax year, you need to take an RMD no later than April 1, 2021. If you receive your RMD related to the 2020 tax year in 2020, you report the income in that year. If you received the RDM for 2020 in 2021, you’ll report the distribution on your 2021 tax year return, but the distribution still counted for 2020 in avoiding a penalty. For this first RMD year, you can split the RMD between the two tax years – in our example above you could withdraw some of your 2020 RMD in 2020, and the rest by April 1 of 2021. This could be useful if you are teetering between tax brackets and don’t want the RMD to push you over in that first year. Consult with your CPA on this if concerned, but if your RMD is small, don’t sweat it.
All RMDs for any year after your 70 ½ birthday year must be withdrawn by December 31 of that year. As such, in our example above, if you receive your 2020 tax year RMD in 2021 (your first RMD in the following year of your 70 ½ year), you still need to withdraw an RMD for 2021 by December 31 of 2021. Really it’s just the first RMD year that is confusing, and after that the distributions are due by year-end and generally won’t be a big deal to figure out.
Once you have figured out your first RMD year, you need to calculate the required amount for that year to withdraw. Your financial advisor is well aware of this requirement and will be able to assist in these calculations, but the gist is you take your age on December 31 of that year and find a correlating distribution period, found on a life-expectancy chart the IRS provides. Next divide the value of the tax deferred accounts, found by taking the value at the end of the prior year, by the distribution period and you have your RMD for the year. At age 70 ½ the general table gives a distribution period of around 27. The IRS provides the following worksheet to assist: https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf.
If you have multiple IRAs, the calculation is applied separately on each, but you can take the total RMD amount from either one or a combination of your IRAs. Also, if you’re still working at age 70 ½, you can generally delay taking 401(k) RMDs for the account held by that employer until you stop working there, but that doesn’t apply to 401(k)s you might have from a previous employer, or any IRA.
Considerations
Taking your RMD can be done in installments during the year, you don’t have to take it all at once. Though there’s no tax advantage to this, there could be personal or investment reasons to do so, and you could discuss this with your financial advisor. You can also take more than your RMD in a year, but know that the excess won’t be credited against any future RMD requirements.
Annuities can add a level of complexity, depending on the type of annuity your account holds, it may or may not be included in your RMD calculation. And if you’ve inherited an IRA, there are some different rules you’ll want to review as well.
If you don’t need the money, you may consider making a qualified charitable distribution (QCD) from your IRA, which will satisfy the RMD for that year. QCDs have become more attractive after tax reform with the temporary changes to itemized deductions. Basically with the standard deduction having doubled, it’s less likely that a person’s normal donations for the year will help their them get over the standard deduction and so there could be no tax benefit to making that donation, on the Federal return. If you use your RMD as a donation (straight to the charity from your account), then you do not have to include the RMD as income in that year! So you’ve made a donation, satisfied your RMD requirement, and helped your tax situation all in one move.
Finally, if you’re in a position to invest in a Roth IRA instead, you can avoid this RMD rule altogether! Roth 401(k)s do require RMDs, though they are not taxed, but if you're wanting to keep all the funds your account, consider rolling to a Roth IRA. Speaking of, there are many advantages of a Roth over a traditional account, maybe I’ll cover this topic in another post!
As always, each person has a unique situation and should consult their tax and financial advisers to consider the entire picture before making decisions.
You’re welcome, Mom. 😊