If you are retired and in your 70s or older, you're generally required to withdraw money from your employer-sponsored retirement plans and traditional IRAs every year whether you want to or not. Under IRS rules for "required minimum distributions" (RMDs), you must take a withdrawal each and every year for the rest of your life the year after you turn 70½. And the tax penalty for missing an RMD or taking out too little can be onerous.
Benefits of Contributing to Tax-Advantaged Plans
Having to take RMDs does little to undercut the advantages of putting money into 401(k)s and IRAs. With a 401(k) or other workplace plan, your contributions up to a generous annual limit are normally free from current taxes. For instance with a 401(k) plan, you can defer up to $18,000 of salary to your account in 2017, or $24,000 if you're age 50 or older, and your employer also may match part or all of your contribution. Then you get to choose from a variety of investment options, and investment earnings inside the account are exempt from current taxes.
The benefits for IRAs are similar. Your annual contributions are subject to specified limits. For the 2017 tax year, the limit is your earned income or $5,500 (or $6,500 if you're age 50 of older), whichever is less. Depending on your situation, your contributions may be fully or partially tax-deductible, especially in the early stages of your career. And here, too, you can choose from a variety of investment options, and earnings inside your account are tax-free.
Tax Treatment of Distributions
However, it's time to pay the piper when you take money out of these retirement plans. Generally, money representing tax-deductible contributions and earnings will be taxed at ordinary income rates of up to 39.6%.
Under the RMD rules, you must begin annual withdrawals by April 1 of the year after the year in which you turn age 70½, followed by RMDs in every subsequent tax year. The amount of the RMDs is based on your account balances at the end of the prior year and life expectancy tables provided by the IRS.
Although the RMD rules apply to everyone, you can postpone distributions from a company plan if you're still working full time and you don't own 5% or more of the company. That exception doesn't apply to RMDs from IRAs.
How to Figure the RMD
Generally, you can look up your age in the IRS table to determine how much of your account you must withdraw each year as an RMD. But there's an exception: If your spouse is your sole beneficiary and is at least 10 years younger than you are, you can use a joint life expectancy table to calculate the RMD. That option normally will produce a smaller required distribution than the one required under the table for individuals and may be especially beneficial to account holders who are in a second or third marriage.
Once you're required to begin RMDs, you can't miss a year. For instance, if you turn 70½ this year, you have until April 1 of next year to take your first RMD—but then you must take a second RMD by December 31 of that year.
If you have multiple accounts, the IRS provides more flexibility for IRAs than it does for employer plans. When you calculate the RMD for IRAs, you can take out the total amount from a single IRA or any combination of IRAs that you prefer, as long as the distributions add up to the required total. But if you have more than one workplace plan, you generally can't arrange your RMDs in this manner. Instead, you must take an RMD from each plan, based on the life expectancy table and the account balance.
Although these rules are complicated, you need to understand what's required of you, because the penalty for failing to take an RMD is severe—50% of the amount you should have taken. For example, suppose you're required to take a $10,000 RMD this year and you withdraw only $3,000. You'll owe a penalty of $3,500 (50% of $7,000 difference), on top of the regular income tax you have to pay.
But RMD rules don't apply to Roth IRAs during your lifetime. You can leave a Roth intact for as long as you like. However, when you die, your beneficiaries who receive Roth assets then have to comply with the RMD rules.
These rules can be tricky and you don't want to stumble into a huge tax liability. We can provide guidance with respect to your particular situation.
This article was written by a professional financial journalist for Preferred NY Financial Group,LLC and is not intended as legal or investment advice.