Retirement accounts, such as IRAs and 401(k)’s, are great savings vehicles. They allow you to save on a tax-deferred or tax-free basis, leaving more of your money to experience compound growth.
Unfortunately, we can’t hold retirement accounts indefinitely. It all comes down to taxation: the IRS doesn’t like waiting to receive their share of taxes. As a result, retired account holders must make yearly withdrawals, called required minimum distributions or RMDs.
What are RMDs?
The required minimum distribution, or RMD, is the amount that the IRS mandates you withdraw from your retirement accounts each year.
How is my RMD taxed?
Your payment may or may not be taxable. If you own a tax-deferred retirement account, meaning that you saved untaxed dollars, you will pay income taxes on withdrawals. Examples of tax-deferred accounts include Traditional IRA, 401(k), SEP IRA, and SIMPLE IRA. On the other hand, if your payments come from a tax-free (Roth) account, you won’t owe anything.
One important exception: some account holders in higher tax brackets have made contributions to a Traditional IRA or 401(k) that they were not able to deduct on their taxes. The amount of their retirement account that represents these non-deductible contributions will return to the account holder tax-free. As a result, a portion of the yearly RMD won’t be subject to income taxes.
Another important exception (this is the tax code – exceptions abound!): for account holders who don’t need the extra income from their retirement accounts, the IRS allows you to satisfy up to $100,000 of your RMD by donating directly to a 501(c)(3) charity. This is called a Qualified Charitable Distribution, or QCD. This provision, which had been a tentative strategy reapproved yearly during the last few weeks of the year, is now a permanent part of the tax code.
When do RMDs start?
Your RMDs begin after you turn 70 ½. If your birthday is on or before June 30th, you will start in the year you turn 70. Otherwise, if your birthday is on July 1st or later, you will start the following year.
For account holders still in the workforce, you are not required to withdraw from your 401(k) or other employer-sponsored retirement plans while you are still employed with your company, regardless of your age. However, there is an exception for business owners. If you are a 5% or more owner of the business sponsoring the retirement plan, you must start taking withdrawals at age 70 ½, whether or not you’ve retired.
When is my RMD due?
Generally, your RMD is due by December 31st of the year for which it is calculated. There is, however, an exception for new septuagenarians. If it’s your first RMD, you have until April 1st of the following year to withdraw your funds. And yet, be aware that if you wait until the following April 1st, you will still need to take a second distribution for that year by December 31st.
For example, if 2017 is your first year you have an RMD, you can wait until April 1, 2018 to make your withdrawal. If you decide to wait, you will need to make a second withdrawal for 2018 by December 31, 2018.
How much do I need to withdraw?
These withdrawals are typically based on your life expectancy, divided by your retirement account balance as of December 31st of the previous year. However (exception time again), if your spouse is the sole beneficiary and 10 or more years your junior, your withdrawals are based on your joint life expectancy, resulting in a lower required amount.
Most custodians provide a yearly statement with an RMD amount based on your age. However, note that this amount is usually based on your single life expectancy; if you are eligible for the joint life expectancy rules above, you may need to calculate your RMD yourself.
How about inherited retirement accounts?
RMDs also apply to inherited, or beneficiary, retirement accounts. If you inherited a retirement account from someone who was not your spouse, you will need to begin even before age 70 ½. Withdrawals are generally due by the end of the year following the year of the original account holder’s death. Otherwise, you must pull out the entire balance within 5 years after date of death.
For example, suppose you inherited an IRA from your great uncle who passed away in 2017. Your first RMD payment would be due by December 31, 2018. Otherwise, if you skip this payment or decide not to make yearly draws, you would need to withdraw the entire account balance by 2022.
Different rules apply for spouses. If you inherited a retirement account from your spouse and don’t need the funds right away, you can treat the inherited account as your own. This way, you won’t need to start withdrawals until age 70 ½.
On the other hand, some younger spouses who need the extra funds may decide to keep the account as an inherited account. If you are younger than 59 ½, most withdrawals from your retirement accounts (except a few special cases) will face a 10% penalty, in addition to your income taxes. This can be an issue for spouses who need access to the assets now but are significantly below the minimum age. By electing to treat the account as inherited, a spouse can bypass this restriction and freely withdraw funds penalty-free.
What about Roth IRAs?
Just like anything else in the tax code, there are exceptions to the RMD rules above. The major exception is for Roth IRAs. You do not need to make yearly withdrawals from a Roth IRA in your own name. Because Roth IRAs are funded with after-tax dollars, you can keep the assets indefinitely – the IRS has already received its “cut”. Note that this rule does not apply to Roth 401(k)s, which still mandate a yearly mandatory draw.
And, of course, there is an exception to the Roth IRA exception above. If you’ve inherited a Roth IRA from someone other than your spouse, you must start RMDs the year after the original account holder’s death. These payments will not be taxed, since they are coming from a tax-free retirement account. For a Roth IRA inherited from your spouse, you have the option to treat the account as your own and skip the RMDs altogether.
Still have questions?
With so many factors to consider, determining your RMD and the best strategy for making payments can be a frustrating process. We would be more than happy to assist with any retirement account questions you have. Contact our office today for more information.
Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.