Year-end Topics: RMDs

There’s a multitude of tasks that financial planners like me focus on as we approach the end of the year. Among them is the complicated issue of Required Minimum Distributions. This is a simple yet potentially thorny issue to contend with, so here’s a rundown of some of the important aspects.

You’ve saved for years and earned a tax deduction on contributions most (or all) of the time along the way, so the tax man eventually wants to generate some revenue. This is why distributions are taxed as ordinary income. Also, forcing minimum distributions from your retirement account is the government’s way of reducing how much you can accumulate tax-free during your lifetime.

The result is that once retirement savers pass age 70, they have to start taking out a required minimum each year. This is a percentage of a retirement account’s value as of the end of the previous year. Initially a modest amount of about 3.6%, the required percentage increases each year as the saver ages. This is based on a table published by the IRS easily found by simply Googling “RMD table”.

But what happens at age 70.5? All that half year means is that you’ll start taking your first RMD in the year that occurs. This leads to confusion. Say someone turns 70 in December and wants to know when to take their first RMD. It’s the following year because that’s when they turn 70.5. Nothing else needs to happen on that date; it’s just a marker.

The following year, and every year after for life, you take your distribution by the end of the calendar year. You can do so monthly, sporadically throughout the year, or all at once at year-end, it doesn’t matter so long as you’ve at least distributed the minimum. And the price of failure is steep – a penalty of 50% of the amount you were supposed to distribute!

Fortunately, the government gives you a pass on messing up the first time. Instead of the year-end deadline, savers have until April 1^st of the following year to take their first RMD. The problem with this, however, is that during that second year you’d take two RMDs, the one missed plus the current one, leading to extra income to pay tax on.

All of this leads to some common questions, so I thought I’d answer them below:

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Is there any way to “shelter” RMDs from tax? The simple answer is no. As I mentioned above, the government has been waiting to tax this money and they’re not going to give up easily.

The only way to avoid tax on RMDs is to give the money away. Seriously. The government will give you a pass on taxes if you give some or all (up to $100k per year) of your RMD directly to charity. “Directly” is italicized because the money has to come from your account custodian and not your checking account.

How hard is the RMD math each year? For most people it’s simple because each account custodian does the math and typically notifies you of each year’s RMD amount.

If you have multiple accounts, do I have to take an RMD from each one? No, you can aggregate distributions across accounts. For example, say you have one account that you like and another that you don’t. You can simply add up both RMDs and take the total from one.

Can I aggregate across my household, say my spouse’s IRA and my own? Nope, RMDs are personal. If both spouses are of age, then each has to take their own RMD.

Since I have until April 1^st of the following year for my first RMD, should I wait to take it? As I mentioned previously, the downside of waiting is that you’d be taking two RMDs that year and, since it’s all taxable, would mean a heavier tax bill. Maybe you’re currently expecting higher income and you want to defer “extra” income to the next year, that could be a reason. Otherwise, it’s usually best to take it that first year.

How about Roth conversions, can they help? While that’s a whole other blog topic, here’s the Reader’s Digest version of an answer – no, they can’t help. At least not really.

Essentially, with a Roth Conversion you’re prepaying taxes, not avoiding them. Converting money from your IRA or 401(k), for example, to a Roth causes the converted amount to be taxable that year. Then, hopefully at least five but more like 10+ years later, the money in your Roth wouldn’t be taxable or subject to an RMD.

Also, the government doesn’t let you put your RMD dollars into a Roth. You’d take the RMD first, pay taxes, and then convert other retirement money, which of course is also taxable that year. This makes Roth Conversions expensive when you’re taking RMDs.

We’ll touch on Roths more in next week’s post. Until then, happy Holiday shopping!

Have questions? Ask me. I can help.