Your obligation to withdraw and pay tax on your required minimum distributions, known as RMDs, is mandatory.
This IRS requirement pertains to all money held in qualified accounts. A qualified account is any investment account that you have funded with pretax money such as; 401(k)s, 403(b), IRAs, 457s etc. Your first RMDs are due by April 1 following the year you turn age 70½. For all subsequent years your distribution must be taken by Dec. 31.
The amount of your RMD each year is controlled by applying the IRS formula to your prior year ending account balance for each qualified account. The IRS provides a handy worksheet for RMD calculations which you will find in this link:
Here is an example of how taxes are calculated on your RMD withdrawal, as previously stated, the RMD is based on the prior year ending account balance. Each qualified account has to be calculated separately. Let’s say your RMD is $20,000, this is claimed as income on your tax return. If you are in a 20% tax bracket then you would owe the IRS $4,000 tax on the withdrawn RMD.
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Once your RMD is withdrawn and the tax is paid you would have $16,000 to spend or reinvest. You cannot reinvest the RMD money back into any form of a qualified account. Since your retirement will most likely span 10 to 35 years, it would be wise to reinvest the $16,000 in a nonqualified account so you have that money available down the road if needed.
Miscalculation or nonadherence to the RMD rule will result in a steep IRS penalty. At this writing the penalty is 50% of the amount not withdrawn.
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Continuing with the above example, if you made a mistake calculating your RMD and withdrew only $18,000 instead of the actual $20,000 due per the IRS formula, the $2,000 not withdrawn will have a 50% penalty thus you will owe the IRS an additional $1,000 plus you will be required to withdraw the additional $2,000 RMD and pay taxes on that also. You would have ended up paying $5,000 instead of $4,000. If you completely forgot to withdraw the $20,000 then the penalty would be $10,000 plus taxes due on the RMD once withdrawn. The penalty is severe and adherence to the IRS RMD rule is important.
Unfortunately, many people wait until they are in their late 60s, usually just before age 70, to address the matter of required minimum distributions. Planning in advance of your RMD obligation offers an option to reduce your RMDs utilizing an IRA conversion to a Roth IRA. This strategy, if applied before retiring, little by little each year, can create two substantial benefits for you during your retirement years:
1.) Your mandatory RMDs will be minimized.
2.) The Roth IRA will provide you with tax-free growth and no RMD obligation during the account owner’s lifetime — however inherited Roth IRAs are subject to RMDs.
Conversion of IRA money into a Roth IRA will up your taxable income in the year of the conversion; exact calculations are important here so you don’t inadvertently move yourself into a higher tax bracket. Plus, you need to have the money outside of the IRA to pay the taxes due on the amount of the conversion. Planning in advance and converting small amounts of your IRA each year to a Roth IRA will allow you to make the taxes due manageable. Consult a tax professional to help with the calculations. Does an IRA conversion to a Roth make sense for everyone? No, not necessarily. Review this concept thoroughly with your tax professional to see if you might benefit from the strategy.
If you have IRA annuities your annuity company will calculate the amount of RMDs due on the qualified IRA annuity and will allow the withdrawal of the RMD without a surrender charge. However, if you have an IRA annuity that carries a life income benefit option and you planned on that life income benefit, for a specific purpose, to start well past age 70½ but then take a RMD withdrawal from the IRA annuity starting at age 70½ the amount of life income benefit may be dramatically reduced thus causing you an income shortage later in retirement.
The key to getting around this potential problem comes with appropriate planning, when creating a life income plan involving IRA annuities with a life income benefit option you will be well served to have an IRA investment account also.
At the time the RMDs are due on the IRA annuity you can have your insurance company calculate the RMD then withdraw the actual RMD, which is due on the IRA annuity, from your IRA investment account. This approach is allowable for IRAs and will keep the life income benefit feature intact until you choose to begin your life income. Once monthly life income starts on your IRA annuity it will usually be enough to satisfy the RMDs due on that particular account.
As with all IRS rules, required minimum distributions can be complex. There are different applications of the rule for inherited IRAs and inherited Roth IRAs as well as for Thrift Savings Plans, Back Door Roth IRAs, working past age 70 for folks who are still contributing to an employer-sponsored plan and for those who will receive a pension annuity but still have IRA accounts outside of the employer sponsored plan.
Seek a tax specialist to review your specific situation. Be careful — the 50% penalty looms in the background for those that have not researched their own specific RMD obligation.
