This month I have been asked multiple times about required minimum distributions (RMDs). This is an important topic for people to understand because the IRS penalties for not taking these distributions correctly can be severe.
Let’s start off and explain what a RMD is. The current tax code allows individual taxpayers to put retirement savings into pre-tax retirement accounts, such as traditional IRAs and 401(k)s. By doing so, individual taxpayers are given a tax deduction from their income in the year of the contribution. The principal and earnings on these accounts are tax deferred until withdrawn, making it a great retirement savings tool for individuals. But like all things that appear too good to be true, there is a catch. The federal government requires the taxpayer to withdraw funds from these retirement accounts once the taxpayer reaches the age of 70 ½. This withdrawal is known as the required minimum distribution or commonly referred to as the RMD. There is current legislation out there that may increase the RMD age past 70 ½ in future years, but the legislation has not passed as of today.
The RMD is calculated by taking the taking the pre-tax retirement account’s balance as of December 31 of the previous year and dividing it by the amount from the IRS’s distribution table. This calculation is done every year once the account holder hits the age of 70 ½. The distribution table is scaled to require a smaller distribution at first and increases as the individual ages. In the first year, the taxpayer has until April 1 of year two to take out this RMD from their retirement accounts. In year two, the taxpayer must take out the RMD amounts by December 31 of year two and every December 31 thereafter. Failure to take the RMD could result in a 50% excise tax on the amount of the RMD not distributed.
Now that we have defined the RMD, let’s consider three tax strategies that are common is dealing with the RMD. Please note that everyone’s tax situation is different and not all strategies are beneficial to everyone.
Strategy #1: The first strategy is to move retirement funds from pre-tax retirement accounts to a Roth IRA. This is known as a Roth conversion. Roth IRAs do not have RMDs and after five years, the distributions are tax free. The catch—a Roth conversion will require the taxpayer to pay tax on the conversion amount in the year of the conversion. By doing a Roth conversion, the taxpayer lowers his or her pre-tax account balances and RMD requirements in the future. Also, by shifting the balances to a Roth IRA, the balances will transfer tax free to those that inherit. This strategy is ideal for taxpayers in a low tax bracket before obtaining the age of 70 ½, but it can be done after 70 ½ as well. However, the conversion does not qualify as a RMD, and the RMD will be required to be taken out in addition to the conversion if done after 70 ½.
Strategy #2: The second strategy is to determine when to take the RMD for the first time. Determining when to take the RMD is important to the taxpayer as the RMD will increase the taxpayer’s income. Taxpayers are given an extra three months to take out the RMD in the first year when the taxpayer becomes 70 ½. This means the taxpayer can defer the RMD to year two and double up the RMD in the second year. Generally, it is beneficial to defer income as long as you can, but doubling your RMD income in year two could result in a higher tax bracket and increase in Medicare premiums.
Strategy #3: The third strategy is a little more giving than the first two. Thanks to the Tax Cuts and Jobs Act, the standard deduction was essentially doubled, and taxpayers are finding it more difficult to itemize and a conventional charitable contribution may not provide a benefit to the taxpayers as it did in the past. In this case, a qualified contribution deduction from a traditional IRA maybe a useful alternative. A qualified chartable distribution (QCD) is a direct fund transfer from the taxpayer’s IRA to a qualified charity. A QCD transfer is only available after you reach the age 70½ and has a maximum one-time annual contribution of $100,000. The QCD transfer will count towards your RMD for the year and it is not included in your gross income. The QCD must be made before December 31 and cannot be deferred to April 1 like the RMD. This strategy can provide an option for taking the RMD and get a deduction from income. This can be significant advantage for certain high-income earners.
As you can see, there are a lot of options available to you for your RMD, each with their own advantages depending on your personal situation. Not sure what to do next with your upcoming RMD? Start here.