What is a required minimum distribution? (*)
You'll sometimes hear that you have important financial decisions to make when you turn the age of 70 ½. The IRS has never seen a nickel of tax revenue on account you may have started in your early 20's, so now they are wanting to get their due. An RMD or required minimum distribution is the amount that the tax laws require you to take out of certain types of retirement accounts once you reach the age of 70 ½. If you have a traditional IRA, a 401(k) account, 403(b), or other types of retirement plans, then you'll generally have to start taking RMDs once the provisions of the law kick in. The rules apply to certain inherited retirement accounts as well, so be very careful when you inherit an IRA.
Required minimum distributions must be made in cash, and you're generally required to complete the withdrawal by the end of the calendar year. A one-time extension applies that gives you until April 1 of the year following the age of 70 ½ to figure out what your first RMD needs to be, but after that Dec. 31 becomes the deadline, you'll need to pay close attention to in order to comply with the requirements.
Why do RMDs exist? (*)
It's SIMPLE: You haven't even paid tax and the IRS wants your money!
The reason the law forces you to take required minimum distributions has to do with the tax benefits that retirement accounts offer. With a traditional IRA, 401(k), or similar account, you get an up-front tax deduction for the amount that you contribute toward retirement. You also get tax-deferred treatment of any income and gains that the assets in your retirement account generate. That means no tax is due until you start making withdrawals. In other words, without RMDs, you could let your savings sit, untaxed, for your entire life. You could then pass those savings on to your heirs, who could pass it on to their heirs, and so on.
To understand this better, compare how you are taxed on your non-IRA type assets. Typically, you'll have to pay taxes on the dividends you receive each and every year and when you sell an investment, you'll also have to pay taxes on capital gains. If you hold an investment for longer than a year, then the top rates range from 0% to 20% depending on your income, but investments held for a year or less can cost you anywhere from 10% to 37% in taxes. Over time, those taxes can take quite a bit of money out of your retirement nest egg.
The IRS as you can imagine doesn't like the idea of letting your investments go untaxed until the day you die, so they implemented RMDs, essentially putting a time limit on how long retirement savers can defer taxation. By forcing withdrawals, the RMD rules make retirement savers eventually pay taxes on their savings — even if they don't really need the money at that point.
When do I have to start taking RMDs? (*)
There are two main types of required minimum distributions, and each has its own rules on when RMDs must begin. If you're the original account holder, then you'll need to start taking withdrawals in the year in which you turn 70 ½ years old. Those who have just turned 70 ½ in a given year have until April 1 of the following year to start taking their required minimum distributions. After that one-time extension, withdrawals in subsequent years must be made by the end of the calendar year.
If you have an inherited IRA, 401(k), or other retirement account, then slightly different rules apply. Spouses have the favorable option of being able to roll over inherited retirement accounts into IRAs in their own names, which simplifies things greatly going forward. However, others are limited to the few additional choices available to any heir: to take a one-time lump sum, to withdraw all money from the account within the first five years, or to take withdrawals stretched out over the course of their lifetime. This last option involves calculating RMD amounts for each year in order to ensure that the heir takes enough money out to satisfy the IRS. (source; www.fool.com)
How big does my RMD have to be? (*)
How to calculate your RMD could be the most challenging part of making sure you comply with the RMD rules. The goal of the IRS is to ensure that you withdraw all of your retirement savings over the course of your lifetime. Accordingly, it refers to life expectancy tables to help taxpayers figure how big each year's RMD needs to be.
Once you have all the necessary information, calculating your RMD is a simple three-step process:
- Add up the value of the retirement accounts that are subject to the RMD rules as of Dec. 31 of the previous year.
- Find the appropriate "distribution factor" by referring to the appropriate IRS life expectancy table that applies to your situation. (More on that below.)
- Divide the total retirement account balance by the distribution factor. The result is how much you'll need to withdraw for that given year.
Finding your distribution factor is where things get complicated. That's because there are multiple IRS tables that provide life expectancy estimates, and different tables apply to various situations. You can find them all at www.irs.gov.
What happens if I fail to take my RMD? (*)
Here is why these are the three most important letters in the alphabet!!
Lawmakers were serious about forcing people to take required minimum distributions, so they made sure the penalties for failing to comply with the RMD rules were strict. If you don't take out the full amount of your RMD by the appropriate deadline, then the IRS charges a CRUSHING 50% penalty on the amount that you should have taken out. Based on current tax rates, that penalty will be larger in every circumstance than the amount of tax you'd have to pay if you withdrew the required amount.
The 50% penalty serves to express how important legislators found it to put limits on the amount of time that taxpayers could benefit from favorable tax laws surrounding retirement savings.
What are the tax consequences of RMDs? (*)
Think about this for a minute. You have never actually received constructive receipt of this income, so this means you are going to be taxed as ordinary income. The challenge is if you let too much money build up in these accounts, you may actually create a tax problem for yourself by having too much money come out of your qualified accounts.
Why R M D are the three most important letters in the alphabet (*)
It's critical to avoid the onerous penalties on those who fail to take their RMD's properly which is why you need to know these three letters in your retirement. By knowing the RMD rules, you'll be able to choose a strategy that lets you preserve the tax benefits of your retirement accounts for as long as you can, without running amuck of the tax code and incurring stiff penalties.
Ted Jenkin is a frequent guest columnist for the Wall Street Journal and Headline News Weekend Express. He is the co-CEO of oXYGen Financial. You can follow him on LinkedIn @ www.linkedin.com/in/theceoadvisor or on Twitter @tedjenkin.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. oXYGen Financial is not affiliated with Kestra IS or Kestra AS. Kestra IS and Kestra AS do not provide tax or legal advice.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.
(* some excerpts in the article are attributed to the www.fool.com and were not written by your smart money moves)
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