The “deferred” part of tax-deferred retirement accounts doesn’t last forever.
Distributions must be taken from Individual Retirement Accounts (IRAs) starting in the year you turn 70.5 – and from 401(k)s at the same age, unless you’re still working for the employer that sponsors the plan. Congress set it up this way because the tax breaks on these accounts are intended to help people accumulate savings for retirement. The Required Minimum Distribution (RMD) exists to make sure the tax benefits of these accounts don’t extend indefinitely – and that you start using these assets, and start paying taxes, in retirement.
And it’s important to get this right: Failure to take the correct distribution results in an onerous 50 percent tax – plus interest – on any required withdrawals you fail to take.
RMDs must be calculated for each account you own by dividing the prior December 31 balance with a life expectancy factor that you can find in IRS Publication 590. Often, your account provider will calculate RMDs for you – but the final responsibility is yours. FINRA, the financial services self-regulatory agency, offers a calculator, and the IRS offers worksheets to help calculate RMDs.
RMDs must be taken by year-end, with one exception. In the year that you turn 70.5 this year, you have until April 1 to take your RMD. However, doing that means you’ll be taking two distributions in the following year – which could have a significant impact on your income taxes.
Although RMDs are calculated for each IRA you own, you don’t have to take a separate distribution from every account. You could total up your RMDs and take it all from one IRA – one that is a poor performer, perhaps, or one that will help you rebalance an account that might be overweight in equities against your overall allocation plan. Christine Benz, personal finance director at Morningstar, talks about ways to do that in this video.
Avoiding tax shocks
It’s bad enough that RMDs may force you to sell assets you might prefer to hold. But RMDs also can trigger an increase in income taxes if they push you into a higher bracket.
RMDS can boost other expenses, too, such as higher taxes on Social Security benefits and substantial high-income surcharges on Medicare premiums.
Social Security benefits are taxed using a complex “provisional income” formula that is determined by adding together your adjusted gross income, tax-exempt income and half your Social Security benefit. If that total exceeds $25,000 for individuals ($32,000 for married couples), then 50 percent if the excess must be included in your income for tax purposes; if it’s over $34,000 ($44,000 for couples) then 85 percent of the excess is included in your income. Planning expert Michael Kitces offers this excellent analysis of Social Security taxation and how it can affect retirees.
RMDs also can tag high income retirees with surcharges on Medicare premiums. These surcharges don’t hit too many older Americans, since most retirees don’t have enough ordinary income to trigger them. But with more people working well past age 65 – and 70 – they can come into play, and RMDs can be an important factor in triggering the surcharges. For example, this year, an individual filer with income over $107,000 (or joint filers over $214,000) pay an additional $104.90 for their Medicare Part B premium. A summary of 2013 Medicare premiums and surcharges can be found at the Center for Medicare Advocacy website.
If you’re over age 70.5, options for minimizing RMDs are few. One that is available – at least this year – is the qualified charitable distribution (QCD), which lets you make cash donations up to $100,000 to IRS-approved public charities direct from an IRA. (QDCs from workplace plans aren’t allowed.) The gifts can be counted toward an RMD and are excluded from your taxable income.
This tax shelter has been on the congressional chopping block for some time and isn’t expected to be extended for 2014.
Another option is converting IRAs assets to an after-tax Roth IRA. You’ll owe income tax on the money you switch into the account in the year of the conversion, but you won’t need to take RMDs in future years (though any beneficiaries would need to take RMDs down the road).
Finally, consider accelerating drawdowns from tax-deferred accounts before you enter the world of RMDs. Savings can be withdrawn without penalty from tax-qualified accounts after you turn 59.5. That will leave you with smaller tax-deferred accounts down the road – hence smaller RMDs.
Bill Meyer, co-founder of SocialSecuritySolutions.com, suggests taking distributions as large as possible so long as they don’t push income into a higher tax bracket. “The idea is simple, he says. “If you reduce your RMDs down the road, you will have more money to spend in retirement.”
Meyer ties this idea to broader strategies for boosting Social Security income and portfolio longevity.
If you’re still too young for RMDs but would like to see what your required distributions might look like in the future, try this handy calculator from Vanguard.
If you’ve inherited an IRA, you may be required to take RMDs, even though you may not be over age 70. Fidelity Investments offers a summary of rules for inherited IRAs from spouses, non-spouses and trusts.