The Required Minimum Distribution Puzzle
By Patricia Small, Director, Tax & Business Services
Many people have accumulated significant balances in tax deferred retirement accounts during their working years. In addition, they may have accumulated significant additional assets and, therefore, do not currently need withdrawals from their tax deferred accounts. Nonetheless, U.S. tax law requires distributions from these accounts beginning at age 70 1/2, whether or not the funds are needed.
There are many rules that can trip up the unwary and subject account holders to penalties if distributions are not taken in a timely manner. Smart planning for these distributions may result in tax efficient strategies to minimize the tax bite.
What is a Required Minimum Distribution?
A Required Minimum Distribution (RMD) is generally the minimum amount that must be withdrawn from your retirement plans each year once you reach age 70 1/2.
These rules apply to traditional IRAs, SEP IRAs, Simple IRAs, SARSEPs, and employer-sponsored plans including 401(k)s, 403(b)s and 457 plans. RMDs are not required for Roth IRAs while the account owner is living, but they do have to be taken from Roth 401(k)’s. By rolling over your Roth 401(k) to a Roth IRA you could avoid the need to take the RMD since Roth IRA’s are not subject to the minimum distribution rules while the account owner is living.
When must the RMDs begin?
Distributions typically begin in the year the account owner turns 70 1/2. However, the first distribution may be delayed until April 1 of the calendar year following the later of:
- The year the plan owner turns 70 1/2, or
- The calendar year the employee retires.
If the plan is an IRA or if the account owner is at least a 5% owner of a business, distributions must begin by April 1 of the year after the account holder is 70 1/2, even if the owner is still working.
Delaying the first payment until April 1 of the year after the owner turns 70 1/2 will require two distributions in that calendar year. The first distribution will pertain to the prior year when the recipient attains age 70 1/2, and the second distribution will be the normal annual distribution. As a result of taking two distributions in one year, this delay may bump plan owners into a higher tax bracket; therefore, depending on earnings, it may make sense to take the first distribution in the year the account owner turns 70 1/2. Be sure to consult your tax advisor to assist with this decision.
How is the RMD calculated?
The account balance is typically paid to the account owner over the life expectancy of the participant according to tables provided by the IRS. The RMD must be taken every year and it is up to the account owner to be sure the correct amount is withdrawn. The distribution is determined based on the balance in the account at December 31 of the prior year. This balance is then divided by life expectancy to determine the RMD, which must be taken by December 31 of the current year.
Age of account owner on December 31, 2018: 70 1/2
Account balance on December 31, 2018: $100,000
Life Expectancy per IRS Table: 27.4
2019 RMD: $3,650
The RMD must be calculated separately for each IRA; however, the total can be withdrawn from one or more IRAs.
Taxation of RMDs
Distributions may be partly taxable or fully taxable as ordinary income in the year received depending on whether there were nondeductible contributions made to the account. (Nondeductible contributions to IRA’s give you basis in the account and are tracked on Form 8606).
If all contributions were deducted in the years they were made then the entire distribution will be taxable. If non-deductible contributions were made then a pro rata portion of each distribution represents a return of basis and is tax-free.
TAX PLANNING OPPORTUNITIES
Qualified Charitable Distributions
If the IRA owner is age 70 ½ or older, a distribution of up to $100,000 can be directed each year to a charity, and the amount will not be included in taxable income. These types of distributions can be used to satisfy part or all of the RMD for the year. The contribution will not be allowable as an itemized deduction, since it is not included in income. (This may be moot, since many individuals are not eligible to itemize deductions as a result of the changes implemented by the Tax Cuts and Jobs Act).
In addition, since the charitable distribution is not included in taxable income, certain deductions and credits based on income will not be impacted. For example, the amount of taxable social security benefits, the cost of Medicare benefits, or state income tax when it is calculated based on adjusted gross income would not be impacted when a distribution is not included in income.
The distribution must be made by the trustee of the IRA to the charity by December 31. The trustee should issue the check directly to the charity, if possible. These types of distributions cannot be made to donor advised funds, private foundations, or supporting organizations.
RMDs are not required for Roth IRAs while the account owner is living. Therefore, in certain circumstances it may make sense to convert part or all of a traditional IRA to a Roth IRA so that RMDs will not be required. This strategy could be employed in the years following retirement but prior to reaching age 70 1/2. There are many things to be considered before converting to a Roth, since there will be taxable income in each year of the conversion. However, there may be other deductions that could offset the taxable income such as alimony payments or a large charitable contribution of appreciated property. In addition, the impact of Medicare premiums should be considered.
Putting the RMD Puzzle Together
There are a variety of considerations with respect to RMDs, such as:
- The year the RMDs should begin;
- Calculating the amount of the RMD;
- Impact on taxable income;
- Basis in the IRA;
- The feasibility of Roth conversion; and
- Qualified donations to charity.
For questions or assistance in computing or determining whether to take a minimum distribution, contact your Marcum tax professional.