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In order to encourage saving for retirement, Congress has created several different types of retirement accounts that enable individuals to deposit money before it is taxed. Income taxes are not paid until the money is withdrawn.
The special tax treatment comes with a number of rules. For example, with few exceptions, the money can’t be withdrawn from one of these retirement savings account until the account holder is at least 59 ½ years old.
Also, the money can’t be left in the accounts forever. After the account holder turns 70 ½ years old, the IRS mandates that withdrawals of specific minimum amounts occur every year. The withdrawals, known as required minimum distributions, or RMDs, are taxed.
There are some strategies for postponing RMDs, including at least one strategy that involves an annuity. But overall, the IRS is pretty strict about adhering to the RMD rules.
If an account holder fails to take a RMD, then he or she is penalized by the IRS.
Retirement Plans That Require Minimum Distributions
All employer-sponsored retirement plans are subject to the RMD rules. And so are traditional IRAs and IRA-based plans.
- SARSEP IRAs
- SEP IRAs
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans
- 457(b) plans
- Profit-sharing plans
- Other defined contribution plans
The rules do not apply to Roth IRAs, which are funded with money on which taxes have previously been paid. Withdrawals from Roth IRAs are not required until the owner dies. Roth 401(k) accounts, however, are subject to the RMD rules.
Why Some People Don’t Like RMDs: Taxes and Medicare Premiums
For many people, having to take money out of an account might seem like a good thing. But some retirees may find the RMD rules onerous, especially if they don’t need the money when the withdrawals are required.
They likely don’t want to have to pay taxes on the withdrawals because it could place them in higher tax brackets. The withdrawals can also lead to Medicare premium surcharges because they count as income in calculating those premiums.
In general, wealthier individuals would benefit more than others if they didn’t have to take RMDs. That’s because people who have less wealth are more likely to need to withdraw a certain amount from their retirement funds to pay their costs. The amounts they must withdraw are less likely to have a substantial impact on their overall tax bracket or their Medicare premiums.
On the other hand, wealthier individuals are more likely to face significantly higher Medicare premiums. In 2017, for example, the standard Medicare Part B premium for most new enrollees was $134 a month. However, a married couple with income more than $428,000 in 2015, would have paid $10,000 for Medicare Part B premiums in 2017.
In fact, some wealthy people avoid the higher premiums by putting money into IRAs, but RMDs can nullify that strategy.
How to Calculate Required Minimum Distributions
The IRS requires account holders to take the first withdrawal by April 1 of the year after they turn 70 ½. The amount of the RMD can be calculated using worksheets created by the IRS. After the first year, you’re required to take your distribution by the end of each calendar year.
To estimate the amount of the required minimum distribution for your account in a given year, take the balance of your account on Dec. 31 of the previous year and divide it by the distribution period, or life expectancy, corresponding with your age on the IRS table.
So let’s say you’re 71 years old, and you have $210,000 in your IRA. You would divide $210,000 by 26.5 (the distribution period on the table corresponding with the age of 71) and arrive at $7,924.53. This is the amount you are required to withdraw.
If you have several accounts with RMDs, you must calculate the RMD for each account. You may add up the RMD amounts and withdraw all the money from one account or any combination of relevant accounts.
This method of calculation applies in all cases, except when the spouse is the sole beneficiary of an IRA and is more than 10 years younger than the account holder. The IRS provides a different IRS worksheet for you to use if your spouse is more than 10 years younger than you and is the sole beneficiary.
Correcting RMD Mistakes
The responsibility of calculating RMDs and making the actual withdrawals falls entirely on the account holder. If you fail to take an RMD when required, or if you withdraw less than required, you will have to pay a 50 percent penalty on the amount you failed to withdraw.
A 72-year-old with an IRA account balance of $300,000 would be required to withdraw $11,718.75. The penalty for not withdrawing the required amount would be $5,859.37, or 50 percent of the RMD for that year.
However, if your failure to withdraw the required amount is due to a mistake, the IRS may waive the penalty if you satisfactorily explain and correct the error.
Depending on the circumstances and type of account, the agency has programs and forms created to address these mistakes. One is known as the Voluntary Correction Program (VCP) and another is called the Self Correction Program (SCP).
Strategies for Postponing or Minimizing RMDs
There are some things you can do to mitigate RMDs. But let’s start with what you can’t do.
You may not put the money you withdraw into another IRA or Roth IRA. After paying taxes, you may invest the money in a non-retirement account.
While you may withdraw more than the minimum amount required, you can’t apply the excess withdrawal to your RMD in a subsequent year.
On the other hand, to lessen the tax impact, you can take your first RMD in two different calendar years. However, that means the second RMD will be added for tax purposes to the amount of the first RMD you took that year.
If you’re still employed when you turn 70 ½ and are participating in an employer-sponsored 401(k), you don’t have to take RMDs from that account as long as you continue to work for that employer. If you’re self-employed and have a SEP-IRA, you still must take an annual RMD from that account once you turn 70 ½, but you can offset the RMD by making contributions to the account.
You can also roll over the amount withdrawn directly into a charitable donation, with no taxes required on the donated amount up to $100,000 a year.
You can purchase a qualified longevity annuity contract, or QLAC, which is a deferred annuity funded with assets from a qualified retirement plan. Federal rules allow you to spend the lesser of 25 percent of your retirement savings or $125,000 to purchase a QLAC.
The amount invested in a QLAC is exempted from RMD calculations until you turn 85 years old.
Legislation Would Raise Age of First Required Minimum Distribution to 75
Congress and President Trump are considering changing the age at which RMDs start from 70 ½ to 75. This is one provision of bipartisan, comprehensive retirement legislation making its way through both chambers of Congress.
The legislation also has provisions aimed at increasing savings in IRAs and 401(k)s, and helping employers provide retirement savings plans. It might also affect annuities.
In addition, Trump signed an executive order in August 2018 directing the U.S. Treasury Department to review rules relating to RMDs with the intention of raising the age at which they must start.
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