What Are Required Minimum Distributions?
Required Minimum Distributions (RMD) are distributions required to be taken annually from traditional IRAs and employer-sponsored retirement plans after you reach age 70.5. You can always take more out of your IRAs and retirement plans in any given year, but you must take, at the very least, the RMD.
The purpose of RMDs is to distribute assets over the remainder of the investor’s lifetime instead of having retirement assets accumulate, continue to defer taxation, and possibly leave the funds as part of their inheritance.
Which Retirement Savings Vehicles are Subject to the RMD Rules?
All Traditional IRAs, simplified employee pension (SEP) IRAs, SIMPLE IRAs, and employer-sponsored retirement plans (401(k), 403(b), 457 plans, etc.) are subject to the RMD rules. This also includes qualified pension plans and qualified stock bonus plans.
Roth IRAs are not subject to RMD rules while you are alive. Your non-spousal beneficiary will be required to take RMDs over the remainder of their life from inherited Roth IRAs.
When Must RMDs Be Taken?
Your first distribution from your IRAs or retirement plans will happen in the year you reach age 70.5. For your first distribution, you have the option of either taking it during the calendar year in which you turn 70.5 or April 1st of the subsequent year.
For each distribution thereafter, you will be required to take your RMD before December 31st of each calendar year until you pass away or until all accounts subject to RMD rules have been taken to a zero balance.
Example 1: You have a traditional IRA. Your 70th birthday was November 16, 2016, so you will reach age 70.5 in 2017. You can take your first RMD during 2017 or you can delay it until April 1, 2018. If you choose to delay your distribution until 2018, you will have to take two distributions in 2018—one for 2017 and one for 2018.
The one possible exception to the rule described above is if you have an employer-sponsored retirement plan and are still working for that employer once you reach age 70.5. You are not required to take RMDs from the retirement plan until you retire, unless you own more than 5% of the company. Your first RMD can be taken in the year in which you retire or delayed until April 1st of the subsequent year. Also, this only applies to your current employer-sponsored retirement plan and not former employer-sponsored retirement plans, unless the assets from the former employer-sponsored retirement plan were rolled over into the current employer-sponsored retirement plan.
Example 2: You own more than 5% of the company you are currently working for. You are turning 70.5 in 2017, but you plan on retiring in 2019. You must take an RMD from your current employer's retirement plan in 2017 or delay until April 1, 2018.
Example 3: You have 2 401(k) plans: one with a former employer and one with your current employer. You are turning 70.5 in 2017, but plan on working until 2019. You are required to take an RMD from your former employer’s 401(k) plan in 2017 or delay until April 1, 2018. You will be required to take an RMD from your current employer’s 401(k) plan in 2019 or delay until April 1, 2020.
How are RMDs Calculated?
RMDs are calculated by dividing the account balance of your IRA or retirement plan account by your life expectancy factor, which can be found in IRS Publication 590-B, Appendix B. Account balances are as of December 31st of the preceding year.
Example 1: You turned 73 years old in 2016. You have 1 IRA that had an ending account balance of $100,000 at market close on December 31, 2016. Based on the ending account balance and your age attained in 2016, you will need to take an RMD of $4,048.58 by December 31, 2017. This is calculated by dividing $100,000 by the life expectancy factor of 24.7.
This process is applied to all accounts that are subject to RMD rules.
There is one exception, which applies to investors whose spouse is the sole beneficiary and is more than 10 years younger than the investor. The life expectancy factor may be based on a longer joint and survivor life table, which is also found in IRS Publication 590-B, Appendix B.
If you have multiple IRAs that are subject to RMD rules, you may take out the RMD from each account individually or the aggregate amount out of a single IRA account that is subject to RMD rules. Inherited IRAs are not included with your own IRAs for this purpose. If you participate in more than one employer-sponsored retirement plan, your RMD is calculated separately for each plan and paid out separately by each plan for each year.
Should You Delay Your First RMD?
You have the option of taking your first RMD in the year in which you turn 70.5 or delay taking it until April 1 of the subsequent year. It may make sense to delay taking your first RMD until the subsequent year if you are anticipating being in a lower tax bracket in the following year, for example.
Remember, if you do delay taking your first RMD until the subsequent year, then you will need to take two RMDs in that year. Recognizing two distributions in the same year may also create potential tax liabilities that can affect other parts of your overall financial plan. This can include the disqualification of certain tax exemptions and deductions that may have otherwise been available to you or increased taxes on Social Security benefits. All factors need to be examined when deciding to take your first RMD and should be done with the assistance of an independent wealth advisor.
Example 1: You are unmarried and reached age 70.5 in 2016. You had a taxable income of $50,000 in 2016 and you expect it to be the same in 2017. You have one traditional IRA and you have determined your first and second RMDs will be $35,000 each. You decided to take your first RMD in 2016 without delay. Your overall taxable income in 2016 will be $85,000, in which you will pay approximately $17,021 in Federal income taxes at a marginal tax rate of 25%. In 2017, you will take your second RMD and your expected tax is going to be almost the same as it was in 2016. Total Federal income taxes paid will be approximately $34,043.
Example 2: Now let’s say you decide to delay taking your RMD until April 1, 2017. Your taxable income for 2016 is $50,000 and your Federal income taxes are $8,271 at a marginal tax rate of 25%. Your taxable income in 2017 will include $50,000 in income as well as two RMDs of $35,000. Total taxable income is expected to be $120,000 in 2017 and your total expected federal income taxes to be paid for 2017 will be $26,637 at a marginal rate of 28%. Total expected federal income taxes paid for both years are $34,908, or $864 more than the scenario in Example 1.
What If You Fail To Take an RMD?
If you fail to take at least the required minimum amount in any given year, you will be subject to a 50% excise tax on any distributions that were not taken.
Example 1: You own one Traditional IRA and compute your RMD for year one to be $10,000. You take out $7,000 from the IRA by the date required. Since you are required to take at least $10,000, you are subject to a 50% excise tax on the amount that wasn’t distributed ($3,000), or $1,500. This is on top of the federal income taxes you will pay on the $7,000 you did take from your IRA.
It is possible to receive an exemption from the 50% tax penalty if you can reasonably demonstrate the required distributions were not taken due to a “reasonable error,” which can include mistakes made by third parties such as custodians.
Can You Satisfy the RMD Rules by Purchasing an Annuity?
Purchasing an annuity with the funds from your IRA or employer-sponsored retirement account can satisfy RMD rules if the following items are true:
- Payments are made at least annually
- The annuity is purchased on or before the date distributions are required to begin
- The annuity is paid out over a period that does not exceed the time period determined for RMDs under regular RMD rules
- Payments, with certain exceptions, are non-increasing
We highly recommend investors speak with an independent wealth advisor before considering any annuity contracts as part of their overall financial plan.
Income Tax Considerations
All distributions will be subject to Federal (and possibly state and local) income taxes. If any contributions were made on an after-tax basis (non-deductible), then only a portion will be subject to Federal (and possibly state and local) income taxes. Make sure you consult a tax professional for determining your tax liability from taking distributions from IRAs or retirement accounts.
Gift and Estate Tax Considerations
It is important to determine whether or not the federal gift and estate tax will apply to you. If you do not expect the value of your taxable estate to exceed the applicable exclusion amount ($5.45 million per individual or $10.9 million for married couples), then this may not be a concern for you. However, state death (or inheritance) tax may be a concern. Please consult a professional tax and estate planning attorney to ensure appropriate strategies are in place to minimize the potential tax liability. We can make recommendations for both, if necessary.
What About Inherited IRAs and Retirement Plans?
After your death, the designated beneficiary will be required to take RMDs from the remaining account balance based on their life expectancy. Spousal beneficiaries are generally allowed to rollover an inherited IRA or retirement plan into an IRA in their own name and delay taking further RMDs until they reach age 70.5.
Required minimum distributions (RMDs) are an important part of an investor’s financial plan. Index Fund Advisors assists their clients by coordinating all required minimum distributions on accounts managed by IFA, by communicating with clients the RMDs for each of their accounts and preparing the necessary paperwork for distributing the assets as the client wishes. If you have any questions in regards to required minimum distributions and how they may affect you, please contact your IFA Wealth Advisor or Client Service Specialist.
About the Author
Derick Kann - Senior Vice President, Wealth Advisor, CFP®
Derick Kann is a Senior Vice President and Wealth Advisor (Series 65) at Index Fund Advisors, Inc. and specializes in long-term investment and retirement planning for a range of clients including high net worth individuals and families, investment committees for endowments, foundations and pension plans, as well as working with companies to construct highly diversified, low-cost 401(k) retirement solutions for their employees. To contact Derick, click here.