Ah, the holiday season. For many this can be the most enjoyable time of year, spending much needed time with friends and family. This is also a notoriously busy time, and sometimes, managing your finances inadvertently gets put on hold. If you're over 70 ½, or will be by the end of the year, forgetting to take your required minimum distribution can have major tax consequences. Here's what you need to know so that you don’t get too caught up in the festivities and incur a major penalty with the IRS.
What are required minimum distributions?
Required minimum distributions (RMD) are the withdrawals that the government requires individuals over 70 ½ to take out of certain retirement accounts each year. These accounts include 401(k)s, 403(b)s, TSPs, and IRAs. The amount that must be taken is determined by what your age will be at the end of the year, and the balance of the account at the end of the prior year. The older you are, the higher the percentage that you must take by the end of each year. As an example, let's say your IRA had $550,000 at the end of last year and you will be 76 years old by the end of this year. To calculate the RMD you would divide the year end value by the distribution period in the IRS table. You would need to take out $25,000 by the end of this year. There is a formula for this calculation, but the easiest and safest way to determine how much you need to take out is to ask your financial advisor. Of course, as the name implies, this is just the minimum that needs to be withdrawn. You can certainly take out more and still avoid a penalty.
What are the tax consequences of the distribution?
Generally, the amount taken out of the account is taxed at your ordinary income tax rate. Most institutions allow you to request that taxes be withheld from the distribution. You should consult your financial advisor or CPA for advice on whether to withhold taxes.
What if I don’t need the money?
A common misconception is that you are required to transfer the RMD as cash to your bank account. However, you can simply transfer the RMD from your retirement account to your regular investment account. You also have the option to transfer investments that are worth at least as much as the RMD amount from your retirement account to your investment account (this is called an ‘in-kind’ transfer). This is an easy way to keep your money invested. In any case, the value of the distribution is taxable.
Alternatively, if you are charitably inclined and already over age 70 ½, you have the option of transferring your RMD (or a larger amount, up to $100,000 per year) directly to a charity. The benefit of this is that the distribution will not be taxable to you. On the other hand, you may not deduct the charitable contribution, but many taxpayers no longer have enough itemized deductions to exceed the increased standard deduction (under the new tax rules) anyway.
What happens if I don't take the required amount?
If you don't remove the required distribution amount from your retirement account by December 31st, the IRS imposes a 50% penalty on the amount not distributed that should have been.1 This is quite a price to pay for forgetting to take a distribution from your account. In our example above, if the $25,000 was not taken, the individual would be subject to a penalty of $12,500!
What accounts do I have to take RMDs from?
Required minimum distributions need to be taken from all traditional IRAs, 401(k), 403(b)s, TSPs and 457(b) plans.
These accounts can be aggregated together and the combined RMD taken from a single account, or separately, if you have multiple IRAs. For instance, let's say similar to the previous example above you have two IRAs, one with $200,000 and another with $350,000. You could take $25,000 from one account, $12,500 from each, or even $10,000 from one, and $15,000 from the other. The important thing is that the total distributions be at least $25,000 to avoid the penalty.
A benefit with IRA accounts is that these distributions only apply to pre-tax traditional IRAs. You are not required to take a distribution from a Roth IRA, regardless of how old you are.
401(k), 403(b), 457(b) and TSPs
Unlike IRAs, 401(k), 403(b), 457(b), and TSP accounts need to be taken pro-rata from each account. So if you have two 401(k) accounts, one with $200,000 and another with $350,000, the proportional required distribution would have to be taken from each - you cannot combine the RMDs and remove it from just one account. In addition to that, Roth 401(k)s are also subject to required distributions, unlike Roth IRAs..
A benefit of your 401(k), 403(b), TSP or 457(b) if you are still working after age 70.5 is that you are not required to take distributions out of the active account. So, if you have two 401(k)s, one with your current employer and a prior one, a distribution is only required to be taken from the previous employer's 401(k). However, when you stop working for your current employer, that 401(k) will then be subject to required minimum distributions.
What about inherited retirement accounts?
You need to take an RMD from EVERY inherited retirement account, including Roth IRAs, starting the year after the owner died. This is regardless of how old you are. The rules for how much you need to distribute are different for inherited accounts, so consult with the account custodian, or your financial advisor on how much you need to withdraw.
What can I do if I forget?
Ideally you will not forget since you are reading this post now. However, if you do forget there may be some options. If this was the first year you were required to take a distribution, the IRS does grant an extension to April 1st of the next year. This would mean that you would have to take two required distributions in the next year. While this does avoid the penalty, it can still lead to a pretty nasty tax hit since you would be about doubling up on the required withdrawal amount.
If this was not your first required distribution, the penalty can still be waived, but requires a little more effort, and some mercy from the IRS! For an exception to be granted, the individual would have to fill out IRS form 5329 and convince the IRS that it was a "reasonable error and that reasonable steps are being taken to remedy the shortfall."2 The IRS grants exceptions on a case by case basis so it's best to ensure the distribution is taken as soon as possible.