Required Minimum Distributions (RMDs) are annual withdrawals that owners of tax-deferred retirement accounts must take once they reach age 70½. Benjamin Franklin popularized the notion that “in this world nothing can be said to be certain, except death and taxes”; in exchange for allowing contributions and growth in tax-deferred accounts to escape taxation for so long, Uncle Sam mandates that the tax bill eventually comes due.
While RMDs must be taken no later than December 31 of each calendar year, clients have more flexibility the first time around, that is, the year in which they turn 70½. The first RMD must be taken by April 1 of the following calendar year. Waiting to take that first RMD, however, may not be the ideal solution, as the second RMD must be taken by December 31 of that same calendar year, resulting in two RMDs – and therefore higher taxable income that may also affect various tax breaks, Social Security, and/or Medicare benefits – in a single tax year. An illustration may be helpful; the table below provides two examples based on clients turning 70½ one month apart.
|Client turns 70||Client turns 70½||First RMD required||Next RMD Required|
|June 15, 2018||December 15, 2018||April 1, 2019||December 31, 2019|
|July 15, 2018||January 15, 2019||April 1, 2020||December 31, 2020|
RMD amounts are calculated based on (1) the account balance on December 31 of the previous year and (2) one of two IRS tables that take into account the joint life expectancy of the account owner and a beneficiary ten years younger or – if the sole beneficiary is the account owner’s spouse, who is more than ten years younger than the account owner – the actual joint life expectancy of the account owner and his or her spouse, which results in a lower RMD. These RMD amounts are separately calculated for each eligible tax-deferred retirement account but – in the case of IRAs and 403(b) plans – can be totaled and withdrawn from any one or more of these respective account types. RMDs calculated, however, from other types of retirement plans such as 401(k) and 457(b) plans must be taken separately from each respective account; this fact alone can be a compelling reason for clients to consolidate all their retirement accounts to a single Traditional IRA and a single Roth IRA (if relevant), greatly simplifying the RMD process (and thereby reducing the risk of a tax penalty arising from administrative error). The following two figures illustrate the impact of using the correct IRS table and consolidating accounts.
Over the course of their careers, clients may work for many employers and amass numerous personal and employer-sponsored retirement accounts. Entering the RMD phase of retirement with these legacy accounts in place greatly complicates the process. In Figure 1, the client has twelve retirement accounts, including Roth 401(k)s and Roth IRAs; the former require RMDs while the latter do not. At best the client must take at least six withdrawals to satisfy his or her RMDs. If the client were to consolidate his or her accounts before RMDs begin, however, two benefits accrue: 1) the client avoids taking $16,391 in income tax-free RMDs when the Roth 401(k) assets are rolled over into a Roth IRA; and 2) one withdrawal, from one account, can now satisfy the taxable RMDs.
Assuming the account owner and spouse qualify, Figure 2 shows the benefits of using the life expectancy table that results in lower RMDs. Compared with the default calculation, the account owner’s RMD is now 20% lower. Coupling account consolidation and the alternate IRS table in this example allows the client to reduce RMDs by 40%, or $26,047, from $64,392 in Figure 1 to $38,345 in Figure 2; those $26,047 of avoided RMDs can now continue to grow tax-deferred or tax-free.
Now that there’s an understanding of when RMDs must be taken, how they are calculated, and what factors can affect their values, what else must be considered?
Personal RMD Considerations
- While custodians will calculate RMDs for account owners, account owners are responsible for verifying the correct amount when filing their taxes, especially if they qualify for lower RMDs as a result of a greater-than-ten-year age difference with their spouses.
- With the exception of the year in which an account owner first turns age 70½, RMDs must be taken by December 31.
- RMDs do not have to be taken all at once; if desired, withdrawals can be taken regularly or irregularly over the course of the year.
- Account owners also have the option to withdraw more than the RMD amount, but all withdrawals are included in taxable income for the calendar year in which they are taken.
- In virtually all cases, failure to take RMDs by December 31 will result in a tax penalty of 50% of the undistributed amount.
- RMDs need not be taken in cash. Account owners can request an in-kind distribution of assets from their eligible retirement accounts to a taxable account, as long as the value of those distributed assets (as of the date of distribution) meets or exceeds their RMDs for the year. Account owners will still owe income tax on the distribution just as if they had withdrawn cash. Their capital gains tax basis for an in-kind distribution becomes the market value on the date of distribution.
- Account owners can choose whether to have taxes withheld when taking their RMDs, as well as how much is withheld.
- RMDs CANNOT be rolled over to another IRA. The whole point of RMDs is for the government to extract its fair share of taxes; attempts to roll over RMDs will trigger excess contribution penalties that can exact a heavy toll if not quickly corrected.
Charitable and Estate Planning RMD Considerations
What if account owners have no need for some or all of their RMDs? What if the RMDs will adversely affect their marginal income tax bracket, the taxation of their Social Security benefits, or their Medicare premiums? What if they are charitably inclined or want to preserve some of their retirement assets for future generations? Account owners have options.
- Consider making a qualified charitable distribution (QCD) directly from your IRA to a qualified charity. QCDs of up to $100,000 per person count toward satisfying annual RMDs without adding to taxable income, potentially preserving certain tax breaks that are dependent on adjusted gross income.
- Consider contributing to a donor-advised fund. While distributions used to fund contributions to a donor-advised fund are still subject to income tax, such contributions may be deductible.
- Roth IRA conversions are another possibility. While the conversion process is itself a taxable event and does not obviate the need to take an RMD in the year of conversion, it is a strategy that can make sense for some clients. As a reminder, Roth IRAs do not have RMDs during account owners’ lifetime, so in addition to tax-free compounding they are tremendous vehicles for fulfilling legacy goals.
Further details are available in IRS Publication 590-B.