At some point Treasury needs to tax all of the dollars tucked away in tax deferred accounts. Their solution? The “required minimum distribution” or RMD. While you can generally start taking retirement plan distributions at age 59 ½ without early withdrawal penalties, you have to start taking distribution at 70 ½ to avoid “late” withdrawal penalties. If you are in that window, planning now can make a big difference in the tax rate that applies to those tax deferred dollars.
Required minimum distribution rules apply to SEP IRAs, SIMPLE IRAs, 401(k)s, Profit Sharing plans, 403(b) plans, and other defined contribution plans. ROTH IRAs are not subject to RMDs. Special rules apply to inherited IRAs and Roth IRAs. Taxpayers include the RMD in taxable income.
For IRAs, the distribution must be made by April 1st of the year following the calendar year in which the person turns 70 ½. After the first payment is made, the payment is then due December 31st of each successive year.
For the rest of the retirement plans mentioned above, the distribution is April 1st following the later of the calendar year in which the person:
Turns age 70 ½ or
Example: John is retired and his 70th birthday is June 30th 2017. John reaches age 70 ½ on December 30, 2017. He must make his first RMD by April 1, 2018. His next payment will be made on December 31, 2018.
The amount of the RMD depends on two factors: life expectancy and the value of each retirement account. The company that is currently holding the individual’s retirement account will usually inform that person of the need to take an RMD and send a Form 1099-R to report the distribution. But be aware, as not all custodians communicate this requirement. If you take less than the required minimum distribution penalties may apply. The amount of the penalty is 50% of the funds not distributed.
Although it is required to take this minimum distribution, individuals are not penalized for taking more. In fact, planning for the timing and amount of your distributions can lower the overall tax rate you might pay on the dollars stashed in your retirement accounts.
Anyone who doesn’t need or want to take the full distribution, should consider giving the remainder to charity. If you make a direct transfer (up to $100,000) from your IRA to a charity, you get to count that money toward your RMD. However, the distribution is not considered income and there is no deduction. Often this netting of income and deduction can create a tax advantage.
It is important to begin planning with advisors regarding RMDs, social security, and capital gains as early as possible. In some cases, the combination of these transactions will push taxpayers into higher brackets and result in unnecessary tax burdens. With proper planning, some of these taxes can be avoided by timing the distributions. If a taxpayer forgets to take their RMD, the IRS may forgive any penalties if the taxpayer was acting in “good faith,” and it is the first time this mistake has been made.
If you have any questions regarding required minimum distributions or anything related to your retirement accounts, please do not hesitate to call your L&B professional at (858) 558-9200.