Many taxpayers enjoy tax-deferred earnings for years in their retirement accounts. It is, however, not something that lasts forever. Uncle Sam comes knocking later on expecting the owners to withdraw taxable cash from their savings. That It is where RMDs come in. Below you will uncover valuable details about these distributions.
Example of Fictitious Case Used to Demonstrate Impact of an RMD
Sam Reynold is turning 70.½ in 2018 with a 401K balance of $700K, IRA balance of $125K and a Roth IRA with a balance of $50K. Sam is fully retired.
What are Required Minimum Distributions?
RMDs (Required Minimum Distributions) are the annual payouts that senior citizens [like Sam Reynold] savers must take from their retirement kitty. The law requires baby boomers to withdraw the money every year from employer-sponsored retirement plans and traditional IRA’s. It applies to individuals who turn 70 and a half.[Since Sam Reynold is turning 70 ½ in 2018, he will need to make an RMD.]
Some pessimists vent that this “required” distribution is merely an opportunity for the government to tax the money that it was lenient on in yesteryears. Without completely eliminating the negative tone, some truths to consider are that the American government has given its citizens the opportunity to save for retirement by:
- Allowing money to be put away in the past without having to pay taxes on that income.
- Allowing the funds to grow each year without paying on the gains made in those accounts.
- In some cases employers may have provided additional money to their employees to encourage them to save, this is called matching funds. Also employers may in some cases share by distributing a percentage of profits with their employees.
The way I see it, the government is merely making a cut off point for the money in the tax deferred account to be completely sheltered from taxes. As of age 70 ½ a portion of the account balance needs to be taken, will count as income and therefore will be taxed by the government.
Accounts that are subject to the distributions include:
- Rollover IRAs
- Inherited IRAs
- Traditional IRAs
- SIMPLE IRAs
- SEP IRAs
- Keogh Plans
- 457 (b), 403 (b) and 401 (k)
[Ok, so in Sam Reynold’s case, his 401K and Traditional IRA will need to make a RMD]
How Does a Person Spend the Money They Withdraw?
It is up to each individual investors to decide what they want to do with the money that they withdraw. They can use the funds for personal expenses. Alternatively the individual can also save the cash in a living trust account. However, they cannot deposit the money back into any retirement account such as an IRA rollover.If a person at age 70 ½ was working, he/she may contribute some money into a Roth IRA which is post tax dollars but grows tax free,may be taken out without being taxed after 59 ½ and is exempt from RMDs).
Do I have to make the distribution in cash? What If I want to hold on to stock ABC?
When taking the distribution, one may choose to do it in cash, but it is not obligatory to take the distributions in that form. The other option is usually referred to as taking the securities “in-kind”, which means take the actual security such as stock ABC from the 401K and having it moved in a regular brokerage account. So if a person owns mutual fund shares or has stock that they would like to hold on to, they can have the shares transferred to an account that is taxable.
[So let’s use Sam Reynold as an example. He has to make a distribution of a little more than $30K.($700,000 401K + $125,000 Traditional IRA=$825,000. Year one, you multiply the total tax deferred accounts that require an RMD by 27.4 (this established by the IRS. It goes down each year. See Chart), so $825K x 27.4= $30,109.49- I used a FINRA RMD calculator. He currently have $10,000 shares of a stock he wants to hold onto, so he transfers those $10,000 shares into his taxable brokerage account. Although he didn’t sell or cash those securities, he will still be responsible to pay the taxes owed on this $10,000 distribution]
How to Calculate RMD
RMDs are typically calculated based on a person’s current age and the account balance for the previous years. There are multiple options available for a person who wants to estimate their required minimum distribution like:
- Using an online RMD calculator– it is a helpful tool that calculates the distributions without too much hassle. Here, you must get IRA end year balances as of December 31st of the year before the calculation year. For instance. If you want results for 2018, you are going to be using 2017 year-end balance.
Two Examples- Let’s Use the Calculator…
A lady born on March 3rd, 1944 with a Traditional IRA balance account of $125k, would need to withdraw 5,252.10 in 2018. (she’s 74).
A man born on November 25th 1946 with a 401K balance of $3.1M. He will be required to withdraw $121,093.75 in 2018 (he’s 72).
- Access worksheets from the IRS’s Official Website. The site also presents more essential details about the distributions.
- Work with a financial professional that has experience working with retirees. He or she will lend a hand with the calculations. This professional should be able to guide you on and identify options available to complete the distribution.(Make sure to ask questions. It’s important to understand how and what the financial professional is doing on your behalf).
It is also essential to note that married couples can take advantage of the joint life expectancy method. It works when someone who is married to a spouse who is over ten years younger and they are the sole beneficiaries. In such a case, the distributions may be less.
Do People In the Workforce Need to Take RMD’S?
The answer is that it depends.
It depends on if the person who reached 70 ½ is still working at an employer which offers a 401K. For this employee, as long as he is employed, he/she doesn’t need to include the balance of that current employers 401K in his RMD calculation. In this case, it is not required for this person to take RMD’s on those funds as long as they own less than 5% of the company where you are working. This person will need to include these funds in their RMD once he/she stops working for that employer. It is however, crucial to understand that if a retirement account holder owns more than 5% of the firm that is sponsoring the retirement plan, they must begin with the distributions in the year he/she turns 70.5, regardless of whether this person has retired or not.
Please note, that this delay only applies to a current place of employment. In the event a person is working and has an IRA or a 401K account from a previous employer, he/she is obligated to make a RMD of those funds.
The First Time One Needs to Take a RMD
The first required minimum distribution that a person must make is by December 31 of the year that one turns 70 and 1/2. However the first year only, the IRS allows the RMD to be paid by April 1st of the follow year.
The challenge with “paying” the first RMD of year 2017 in April of 2018, is that the person also has to “pay” their 2018 RMD by December 31 2018. Essentially making two RMD payments in one year. This will cause a sharp increase in income for that person which will affect taxes due and may impact their government benefits
Remember the total amount that a person has in their retirement accounts, as well as the estimates of IRS life expectancy, determines the size or amount of the distributions.
Senior citizens do not need to go through intensive training to figure out the amount of money that they should get from their IRAs. They can always use online calculators to get the amount they need to withdraw.
Penalties for not taking Out RMDs
Because taking out the distributions is mandatory, individuals who fail to do so may end up facing stiff penalties. The most common one is a 50% penalty on the shortfall or the amount that they do not take. It applies to qualified plan participants who have attained the beginning date and IRA owners. Failure to pay penalties continue to accrue until a person finishes paying up.
Despite the fact that the penalties are usually severe, there is a possibility that they can be waived. It is typically applicable to first time offenders who may qualify for administrative relief under the First Time Penalty Abatement policy.(FTA)
- A person did not have to file returns previously, or they do not have any penalties for three tax years before the year when they faced the consequences.
- An individual has made arrangements or has paid in full any tax that is due.
- A person files all their returns on time, or they request an extension of time to submit their returns.
- People who receive false oral advice from IRS may also qualify for the relief.
What if someone fails to make their RMD?
The penalty for failing to make all or part of the Required Minimum Distribution is very steep, at a rate of 50%. So if someone needed to make a $20,000 RMD in 2017 but didn’t the IRS would penalize this person a whopping 50%, so he’d now owe $20,000 + a $10,000 fine=totalling $30,000 for the 2017 RMD. The same would be true if someone miscalculated and underpaid. So, if the balance on December 31st of the previous year obligated this person to pay $20,000 yet he/she only paid $18,000 the IRS would penalize this person 50% on the balance still owed which is $2000 + the $1000= now $3000 is owed for that year’s RMD.
- Don’t leave this matter to the last minute. Someone entering the pre-retirement time of their life should be determining many things such as when to begin social security? Will I have enough money to live on based on my savings, retirement funds and social security? Will I want to or need to continue working full time or part time during the “Golden Years”? And when will I need to begin taking out my RMD?
- Ask a financial professional like your CPA or financial advisor to project aka guesstimate what the RMD may be and when the RMD should begin. Many such professionals may follow the approach of helping their clients determine/project their individual or family’s cash flow and income statements. This either is a rude awakening for those that are very much off track to meet their standard of living and may need to make life choices such as downsizing, cutting back on current spending and even needing to work thru the beginning of their retirement, on the other hand there are those that are relieved and find a sense of calm when they learn that they are in a better financial position than they believed.
A person nearing the age of 65 should consider having their personal RMD on their radar and as part of their financial planning and retirement discussions. At the very least a RMD will have some sort of impact on the person’s taxable income which should be considered and planned for. Lastly, there is a way to make a RMD without it having to impact one’s income, save taxes by making a Qualified Charitable Distribution. (see the article I wrote about it.)