Avoid Mistakes and Penalties with the ABCs of RMDs

(Couple reviews investment portfolio documents.)


Most people spend years accumulating money in various tax-deferred retirement plans — 401(k)s, IRAs, 403(b)s, etc. Investing for retirement this way is convenient, there’s often some kind of matching contribution from your employer and these plans reduce the amount of income tax paid during your working years.

But there’s a catch that — depending on your age and the type of financial professional you’re working with — you may or may not know much about.

There will come a day when the IRS will demand its cut of the money you’ve been saving … and you can’t say no. Ready or not, when you’re 70A1/2, you’ll have to take required minimum distributions (RMDs) from your qualified accounts and pay income tax on that money.

After 18 years in the financial industry, I’m still amazed by the lack of general knowledge about RMDs. Some people don’t even know there is such a thing. Others are misinformed about the IRS rules (which can be confusing).

Here’s a quick guide. Think of it as the ABCs of RMDs:

A is for Aggregation.

The IRS requires that you calculate the RMD for each tax-deferred retirement account, including:

— 401(k)s, 403(b)s and 457(b)s
— Traditional IRAs (but not Roth IRAs, which are funded with after-tax money and are not subject to RMDs unless the account is inherited)
— Rollover IRAs and inherited IRAs
— Keogh Plans
RMDs are based on the value of the account at the end of the prior year divided by your life expectancy factor (taken from the appropriate table in IRS Publication 590). Once you’ve calculated your RMD for each IRA (including traditional, SIMPLE and SEP IRAs), you can aggregate the total and withdraw your RMD from one or multiple accounts in any combination.

Your 403(b) RMDs also should be calculated separately, and the total amount can be withdrawn from any one or a combination of those accounts. Keep in mind that 403(b)s cannot be aggregated with IRAs.

An RMD from a workplace retirement account, such as a 401(k), is different. Each withdrawal must be taken from its own account.

B is for Beginning Withdrawals.

When should you take your first RMD? The year you turn 70A1/2, you’ll be required to take distributions from all IRAs, and likely most other qualified plans, such as 401(k)s. (With 401(k)s, you can avoid RMDs from your current employer’s plan if you’re still working full time and you don’t own 5% or more of the company. You would, however, need to take RMDs from any previous employer’s plan.)

You need to take your RMD before Dec. 31 each year, except for the year you turn 70A1/2. That first time only, you have the option of waiting until April 1 of the following year. This could be helpful if you’re still working and don’t want to increase your taxable income, or if the RMD could affect the taxes you’ll pay on Social Security income. Waiting, however, means you will have to take two distributions in the next year, which could bump you into a higher tax bracket.

Do the math and figure out which makes more sense for you. But don’t procrastinate and miss your payment: The penalty is a 50% excise tax on the amount you were required to take. (That’s on top of the ordinary income tax you owe on the distribution.)

C is for Consider Your Taxes.

Once you know the IRS rules and you’ve calculated the amounts you’ll likely have to withdraw from your tax-deferred accounts, it’s time to put your full focus on tax efficiency. If you’re reading this and you’re not 70 yet, there’s still time to make adjustments that could keep more money in your pocket, instead of Uncle Sam’s.

Along with strategically timing your first RMD, you may wish to begin converting some of the funds in your tax-deferred accounts to a Roth IRA. You would pay income tax on this conversion amount, but all future gains and withdrawals from the Roth would be tax free (as long as you’re age 59A1/2 or older and have held the account for at least five years), and there would be no more RMDs to worry about.

You can spread the Roth conversion over several years or more if you start in your 60s. By converting smaller amounts each year, you are likely to stay in or around the same tax bracket without triggering a phase-out of your ability to claim personal exemptions while at the same time end up in an overall higher federal income tax bracket as well. This strategy could also make sense if your RMD is going to be significant because you might get bumped up to a higher tax bracket.

Another move with your RMDs from a tax perspective is to consider purchasing life insurance. If you are not using RMD funds for retirement income, RMD payments could be multiplied by purchasing life insurance and paid out to your beneficiaries federal income tax free. If you are in decent health, you could qualify for a significant policy by placing RMD amounts (after deducting taxes from the RMD itself) in a permanent life insurance policy. In addition, many policies have options to use the death benefit towards paying for long-term care, and distributions to cover this type of care can also have tax advantages.

Last, but not least, Congress gives you the ability to transfer your RMD to a charity without claiming it as income. You must have the funds pay directly to a qualified charity and the limit is $100,000 per year. If you are looking to support an organization or your community, this could be a strategic move to consider.

Just remember, the RMD rules are complex, the penalties for missed or miscalculated withdrawals are high and the tax implications are a minefield. One misstep could blow a hole in your retirement plan. Don’t go it alone. Talk to an experienced financial adviser and/or tax professional and weigh the pros and cons about your RMD strategy long before your first withdrawal is due.