How Required Minimum Distributions May Effect Your Retirement Planning

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Required minimum distributions, often referred to as RMDs or minimum required distributions, are amounts that the federal government requires you to withdraw annually from traditional IRAs and employer-sponsored retirement plans after you reach age 70½ (or, in some cases, after you retire). You can always withdraw more than the minimum amount from your IRA or plan in any year, but if you withdraw less than the required minimum, you will be subject to a federal penalty.

The RMD rules are calculated to spread out the distribution of your entire interest in an IRA or plan account over your lifetime. The purpose of the RMD rules is to ensure that people don’t just accumulate retirement accounts, defer taxation, and leave these retirement funds as an inheritance. Instead, required minimum distributions generally have the effect of producing taxable income during your lifetime.

WHICH RETIREMENT SAVINGS VEHICLES ARE SUBJECT TO THE RMD RULES?

In addition to traditional IRAs, simplified employee pension (SEP) IRAs and SIMPLE IRAs are subject to the RMD rules. Roth IRAs, however, are not subject to these rules while you are alive. Although you are not required to take any distributions from your Roth IRAs during your lifetime, your beneficiary will generally be required to take distributions from the Roth IRA after your death.

Employer-sponsored retirement plans that are subject to the RMD rules include qualified pension plans, qualified stock bonus plans, and qualified profit-sharing plans, including 401(k) plans. Section 457(b) plans and Section 403(b) plans are also generally subject to these rules. If you are uncertain whether the RMD rules apply to your employer-sponsored plan, you should consult your plan administrator or a tax professional.

WHEN MUST RMDs BE TAKEN?

Your first required distribution from an IRA or retirement plan is for the year you reach age 70½. However, you have some flexibility as to when you actually have to take this first-year distribution. You can take it during the year you reach age 70½, or you can delay it until April 1 of the following year.

Since this first distribution generally must be taken no later than April 1 following the year you reach age 70½, this April 1 date is known as your required beginning date. Required distributions for subsequent years must be taken no later than December 31 of each calendar year until you die or your balance is reduced to zero. This means that if you opt to delay your first distribution until April 1 of the following year, you will be required to take two distributions during that year — your first year’s required distribution and your second year’s required distribution.

Example:  You have a traditional IRA. Your 70th birthday is December 2, 2017, so you will reach age 70½ in 2018. You can take your first RMD during 2018, or you can delay it until April 1, 2019. If you choose to delay your first distribution until 2019, you will have to take two required distributions during 2019 — one for 2018 and one for 2019. This is because your required distribution for 2019 cannot be delayed until the following year.

There is one situation in which your required beginning date can be later than described above. If you continue working past age 70½ and are still participating in your employer’s retirement plan, your required beginning date under the plan of your current employer can be as late as April 1 following the calendar year in which you retire (if the retirement plan allows this and you own 5% or less of the company). Again, subsequent distributions must be taken no later than December 31 of each calendar year.

Examples:  You own more than 5% of your employer’s company and you are still working at the company. Your 70th birthday is on December 2, 2017, meaning that you will reach age 70½ in 2018. So you must take your first RMD from your current employer’s plan by April 1, 2019 — even if you’re still working for the company at that time.

You participate in two plans — one with your current employer and one with your former employer. You own less than 5% of each company. Your 70th birthday is on December 2, 2017 (so you’ll reach 70½ on June 2, 2018), but you’ll keep working until you turn 73 on December 2, 2020. You can delay your first RMD from your current employer’s plan until April 1, 2021 — the April 1 following the calendar year in which you retire. However, as to your former employer’s plan, you must take your first distribution (for 2018) no later than April 1, 2019 — the April 1 after reaching age 70½.

WHAT IF YOU FAIL TO TAKE RMDs AS REQUIRED?

You can always withdraw more than you are required to from your IRAs and retirement plans. However, if you fail to take at least the RMD for  any year (or if you take it too late), you will be subject to a federal penalty. The penalty is a 50% excise tax on the amount by which the RMD exceeds the distributions actually made to you during the taxable year.

Example:  You own one traditional IRA and compute your RMD for year one to be $7,000. You take only $2,000 as a year-one distribution from the IRA by the date required. Since you are required to take at least $7,000 as a distribution but have only taken $2,000, your RMD exceeds the amount of your actual distribution by $5,000 ($7,000 minus $2,000). You are therefore subject to an excise tax of $2,500 (50% of $5,000).

Technical Note:  You report and pay the 50% tax on your federal income tax return for the calendar year in which the distribution shortfall occurs. You should complete and attach IRS Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” The tax can be waived if you can demonstrate that your failure to take adequate distributions was due to “reasonable error” and that steps have been taken to correct the insufficient distribution. You must file Form 5329 with your individual income tax return, and attach a letter of explanation.  The IRS will review the information you provide and decide whether to grant your request for a waiver.

TAX CONSIDERATIONS

Income tax

Like other distributions from traditional IRAs and retirement plans, RMDs are generally subject to federal (and possibly state) income tax for the year in which you receive the distribution. However, a portion of the funds distributed to you may not be subject to tax if you have ever made after-tax contributions to your IRA or plan.

For example, if some of your traditional IRA contributions were not tax deductible, those contribution amounts will be income tax free when you withdraw them from the IRA. This is simply because those dollars were already taxed once. You should consult a tax professional if your IRA or plan contains any after-tax contributions.

Your distribution may also be income-tax-free if it is a qualified distribution from a Roth 401(k), 403(b), or 457(b) account. Generally, an RMD is qualified if your Roth account satisfies a five-year holding period requirement. If your RMD is not qualified, then generally only the portion of the RMD paid from your Roth account that represents earnings will be taxable to you — your own contributions to the Roth account are returned tax free.

Because RMDs are paid after you turn age 70½, or after your death, they are not subject to early distribution penalties. Income taxes on RMDs paid to your beneficiary after your death are generally calculated in the same manner as if the payments were made to you.

Caution:  Taxable income from an IRA or retirement plan is taxed at ordinary income tax rates even if the funds represent long-term capital gain or qualifying dividends from stock held within the plan. Note that there are special rules for capital gain treatment in some cases on distributions from employer-sponsored retirement plans.

Estate tax

You first need to determine whether or not the federal estate tax will apply to you. If you do not expect the value of your taxable estate to exceed the federal applicable exclusion amount then federal estate tax may not be a concern for you. However, state death (or inheritance) tax may be a concern. In some cases, your assets may be subject to more than one type of death tax — for example, the generation-skipping transfer tax may also apply. Consider getting professional advice to establish appropriate strategies to help reduce and possibly eliminate your future estate tax liability.

For example, you might reduce the value of your taxable estate by gifting all or part of your required distribution to your spouse or others. Making gifts to your spouse can sometimes work well if your taxable estate is larger than your spouse’s, and one or both of you will leave an estate larger than the applicable exclusion amount. This strategy can provide your spouse with additional assets to better utilize his or her applicable exclusion amount, thereby minimizing the combined estate tax liability of you and your spouse. Be sure to consult an estate planning attorney, however, about this and other possible strategies.

Caution:  In addition to federal estate tax, your state may impose its own estate or death tax. Consult an estate planning attorney for details.

GET ADVICE

At Kuderer Financial we help our clients simplify their financial lives. Part of that service is to evaluate your current needs with your future goals. Set up a complimentary consultative meeting to talk about how RMDs can fit into your Retirement Plan.

Prepared by Broadridge Investor Communication Solutions, Inc.