Ed Slott is an expert on IRA’s. I have edited his remarks here to add the Money Mastery perspective, but details he shares are a fantastic guide. First, know that anyone turning age 70.5 years old in 2016 must take their Required Minimum Distributions (RMD’s) from their IRA. As Ed teaches, the first time can be delayed until April 2017, but then in 2018 it cannot, thus two withdrawals will occur in one year. This may push you into a higher tax bracket, so be careful.
Why is this information important? When a person does not take their RMD’s, they are subject to a 50 percent tax penalty! And then you pay income tax on top of that. Can you imagine having to pay 70 percent tax on retirement income? Wow! Don’t let this happen to you.
The Internal Revenue Service rules require retirement investors to begin withdrawing a certain amount annually from traditional IRAs and 401(k) accounts in the year that they reach 70.5 years of age. Roth IRA’s are exempt from RMD’s. The deadline for most required minimum distributions (RMDs) is December 31, so this is a good time to double check your retirement accounts, or those of any family members you might be assisting with money management. Missing the RMD deadline leaves you on the hook for an onerous 50 percent tax penalty – plus interest – on the amounts you failed to draw on time.
The RMD rules exist to limit the tax benefits of these accounts to the years when you were saving for retirement, not during the retirement years themselves — after all, the government thinks it’s let you out of paying taxes on this money long enough, and now you have to withdraw and pay the income tax on the money withdrawn in the year of your draw down.
But RMDs can be a real headache. They can trigger an increase in income taxes if they push you into a higher bracket, and they can trigger higher taxes on Social Security benefits and substantial high-income surcharges on Medicare premiums.
Basic Rules to Be Aware Of:
- One exception to this 70.5 age required withdrawal is for those people who are still working for the company that sponsors their 401(k); in this case the IRS rules do not require that you take a distribution.
- Another exception to the December 31 deadline: In the year that you turn 70.5, you have until April 1 to take your RMD. However, waiting until April means you will be taking two distributions in the following year, so not a good idea to wait.
- If you inherit an IRA, distributions are required unless you received it from a spouse.
- RMD’s must be calculated for each account you own by dividing the prior December 31 balance with a life expectancy factor that you can find in IRS Publication 590. Often, your account provider will calculate RMDs for you – but the final responsibility is yours. Search online for the formula and you can do the calculations yourself.
Slott warns, “People often ask which of their RMDs can be combined and taken from one account — they often think it doesn’t matter where the distribution comes from,” he said. “But they’re wrong.”
“The IRS rules require that RMDs must be calculated separately for all the accounts you own. In some cases, RMD amounts can be added together and the distribution taken as you like from one or more of the accounts,” says Slott. “Any type of IRA accounts can be aggregated, which means you could total up your RMDs and take it all from one IRA — one that is a poor performer, perhaps, or one that will help you re-balance an account that might be overweight in equities in your allocation plan.
“Multiple 403(b) accounts also can be aggregated, but you cannot satisfy an RMD from an IRA with funds from a 403(b), or vice versa. And 401(k) RMDs cannot be aggregated at all — if you have more than one 401(k) account from former or current employers, those RMDs cannot be aggregated — you must take the RMD from the accounts separately.
Keep It Simple
Slott notes that simplicity is the retirement investor’s friend when it comes to RMDs — consolidating IRAs reduces paperwork and complexity. Likewise, consolidating 401(k) accounts during your career makes it easier to track investments and RMDs — and even avoid them if you are still working at age 70.5.
The 50 percent penalty is a tough pill to swallow, but Slott says the IRS often will waive the penalty if you make a mistake but can offer a “reasonable cause” for the error. First, take corrective action immediately by taking the required distribution. Then, file IRS Form 5329, explaining in one written sentence how you screwed up. “You were confused by the rules, or you miscalculated, or your financial adviser made an error,” he suggests.
One last bit of information, the RMD calculation goes up the older you get. For example at age 71 the RMD is about 5 percent of the balance in the deferred accounts, but when you are age 80, it is 12 percent of the balances. If you live long enough, the RMD can force you into a higher tax bracket and require your Social Security benefits to be included for income tax also.
Knowing the rules is so important. This post is to serve as a reference guide to anyone approaching age 70, or for children who know their parents are approaching age 70. My guess is the government just wants tax money and feels it has waited long enough, so you are not going to keep living and not pay your share of tax. Knowing these important rules could save you up to 70 percent in taxes on your retirement funds.