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Contributions made to an IRA are fully tax-deducible, allowing consumers to save more money for the future by taking advantage of tax-deferred status. However, when you start withdrawing from a traditional IRA, the withdrawals will be taxed as ordinary income, which is why you should want to defer withdrawals as long as possible. The problem is the government doesn’t want to wait any longer for its tax revenues. That is why it added the Required Minimum Distribution (RMD) provision to the tax code.
Tax Deferral is Not Forever
The Required Minimum Distribution provision says that, in the year that a consumer turns 70 and a half, there is no choice but to start withdrawing from an IRA at a certain rate or pay a huge penalty.* Any amount that is not withdrawn as required will be charged a 50 percent penalty fee. For example, if a required RMD is $20,000 for the year, a failed withdrawal would warrant a $10,000 penalty. So it is imperative to understand how the RMD works and what you need to do to comply with the rule.
How Required Minimum Distributions Work
The Required Minimum Distribution is triggered the year you turn 70 ½. In the first year of your RMD, you have until April 1 of the year following the calendar year you turn 70 ½ to take the withdrawal. So, if you turn 70 ½ in July of 2018, you have until April 1, 2019 to withdraw the RMD. Every year following the initial withdrawal, you will need to take an RMD by December 31. It is important to point out that if you decide to postpone your initial RMD until April 1 of the following year, you will also need to take another RMD by the end of the year.
Your RMD amount in any given year is calculated using the remaining balance of your IRA or 401(k) and your life expectancy factor, which is found in the IRS’s Uniform Lifetime Table. Let’s say you turn age 70 and a half in 2018 and have a year-end balance in 2017 of $800,000 in an IRA. Your life expectancy factor is 27.4. Dividing this IRA balance by the life expectancy factor, the RMD for the current year is $29,197.
He can take the withdrawals weekly, monthly, or as a lump sum. Because the IRA balance and the life expectancy factor change year-to-year, the RMD calculation must be made each year. The IRS website offers an easy RMD worksheet to make the calculation. If both spouses have an IRA or 401(k) plan, the RMD calculation must be made separately and both spouses will take an RMD each year.
If you have more than one retirement account, such as an IRA and a 401(k) plan, you will need to make the RMD calculation and take an RMD from each account separately. However, if you have multiple retirement accounts of the same type (i.e., two IRAs or two 401(k) plans), you can take your total RMD for the year from one account. This is one reason why you should consider rolling all of your retirement accounts into a single IRA.
Keeping Track of Your Required Minimum Distributions
Obviously, you never want to miss an RMD. You also don’t want to under-withdraw. While it’s easy to calculate your RMD, you should get some help from your plan sponsor or custodian. Your annual plan statements should include your RMD amount for the following year, and some plan sponsors will even send out a reminder if you haven’t taken your RMD by a certain date. If, for any reason, you fail to take your RMD on time, you can apply for a penalty waiver as long as you take the withdrawal and report it on your taxes within a certain period of time.
Make Required Minimum Distributions a Part of Your Retirement Planning
For people who plan and save well for retirement, it would be important to incorporate RMD planning. That might include a strategy to diversify your income sources so as to minimize the impact of RMDs on your taxes and the rate of drawdown from your assets. For example, you might plan on taking minimal withdrawals from your IRA or 401(k) earlier in retirement to avoid having to take larger withdrawals after age 70 ½.
You could also invest a portion of your IRA assets in a Qualified Longevity Annuity Contract (QLAC). The portion of your IRA invested in a QLAC is removed from the RMD calculation allowing you to defer your taxes until after you turn 85. QLACs are gaining popularity as a way to ensure you never outlive your income. However, any strategy involving your RMDs and retirement accounts should involve the guidance of a qualified retirement or tax specialist.
*The RMD rule does not apply to assets held in a Roth IRA. It does apply to a Roth 401(k) plan.
Author: Jeff Gitlen