Tax deferral is a powerful wealth-building tool, enabling individuals to delay paying taxes on their investment earnings and allowing more of these earnings to compound over time. But unlike diamonds or that cast-iron skillet that you inherited from your grandmother, tax deferral doesn’t last forever. Planning for required minimum distributions (RMDs) is an important part of a sound retirement income plan.
Required minimum distributions reflect the amount that must be withdrawn each year from tax-deferred retirement accounts, including Individual Retirement Accounts (IRAs) and defined contribution plans such as a 401(k) or 403(b). Distributions must commence by April 1st of the year following the year that the account owner attains 70 ½ years of age, and failure to satisfy the annual RMD requirements results in the imposition of one of the most draconian penalties in the tax code- a 50% levy on the amount that should have been distributed. The annual RMD is based on the closing account balance on the final day of the prior year and the distribution period listed in the IRS Uniform Lifetime Table (with a different table used for married account owners whose spouse is the sole beneficiary, and when that spouse is more than ten years younger). Using the more familiar Uniform Lifetime Table, the RMD for someone that attains age 70 ½ in 2018 and owns an IRA that had a $200,000 account balance as of the close of business on December 31, 2017, is calculated as follows: $200,000/27.4= $7,299.27. This amount must be withdrawn from the IRA prior to April 1st of 2019. Distributions in future years must be made prior to December 31st, and the divisor will decrease each year, resulting in a proportionately larger required distribution.
While RMDs must be taken from most tax-deferred accounts when the account owner reaches age 70 ½, there is an exception made for defined contribution plans when the account owner is still employed and does not own 5% or more of the firm sponsoring the plan. Roth 401(k) accounts, although subject to RMDs, also allow for this continued deferral, and Roth IRA owners escape RMDs entirely- although this is not true for those that inherit a Roth IRA account following the owner’s death. That is, unless they happen to be the surviving spouse of the original account owner, the sole primary beneficiary, and elect to transfer the proceeds to their own Roth IRA. If your head is ready to explode, remember that where mind-numbing complexity exists savvy planning strategies are sure to follow.
Required Minimum Distributions: important considerations
- Required Minimum Distributions apply to traditional and rollover IRAs, SEP-IRA, SIMPLE, and Keogh plans. They are also required for employer-sponsored defined contribution plans such as 401(k), 403(b) or Employee Stock Ownership Plans (ESOP).
- Required Minimum Distributions must commence by April 1st, 2019 for qualifying retirement plan account owners that were born between January 1st and June 30th of 1948. Those attaining their 70th birthday later in the year must begin their RMD by April 1st, 2020.
- Deferring the initial RMD to April 1st of the following year will result in two RMDs for that year- e.g., the 2018 RMD that must be withdrawn prior to April 1st and the 2019 RMD that must be withdrawn prior to December 31st, 2019. This may result in unintended consequences, including increased taxation of Social Security benefits or an increase in Medicare Part B and Part D premiums.
- Required Minimum Distributions are assessed at the individual taxpayer level. Married couples may not use distributions from their spouse’s retirement account to satisfy their RMDs.
- Required Minimum Distributions are based on the account owner’s life expectancy (IRS Uniform Lifetime Table), unless the account owner’s sole primary beneficiary is a spouse that is more than ten years their junior. In this case, the IRS Joint Life Expectancy Table is used. Under this method, the RMD will be lower because the couple’s joint life expectancy is longer than that of the account owner.
- Required Minimum Distributions do not have to be taken in cash. A transfer of the shares of the underlying investments into a taxable account may be used in lieu of selling shares and withdrawing the proceeds.
- Required Minimum Distributions from multiple IRA accounts owned by the same individual may be aggregated and withdrawn from any one of those IRAs, however, RMDs from an inherited IRA or defined contribution plan must be calculated separately and may not be aggregated. The lone exception is the case of two or more 403(b) plans, which may be aggregated.
- Required Minimum Distributions do not have to be withdrawn from employer-sponsored defined contribution plans, such as a 401(k) if the participant is actively employed at the firm sponsoring the plan and does not own 5% or more of the firm. Otherwise, RMDs are required.
- Nondeductible IRA contributions should be tracked on IRS form 8606. Although an IRA that contains a combination of deductible and nondeductible contributions is subject to RMDs based on the full account value, only the deductible portion and growth in the account is subject to tax.
- Roth 401(k) plans are subject to the same RMD rules that apply to a traditional tax-deferred 401(k). Required Minimum Distributions are never required for the owner of a Roth IRA, although they are required for non-spousal beneficiaries that inherit the account following the death of the account owner.
- Beware the five-year rule, which states that five tax years must pass from the date of the first contribution to a Roth IRA or Roth 401(k)- e.g., a Roth IRA contribution made for tax year 2018 is considered to have been deposited on January 1st, 2018, even though the contribution can be made as late as April 15th, 2019. In this example, distributions made before January 1st, 2023 are considered non-qualified, and the earnings are subject to tax.
- Rollovers from a Roth 401(k) to a Roth IRA are allowed, but it is important to note that the Roth 401(k) holding period does not transfer to the Roth IRA. The Roth 401(k) rollover will inherit the same holding period as the Roth IRA. For example, a Roth 401(k) with a six-year holding period that is rolled over to a Roth IRA with a two-year holding period will inherit the Roth IRA’s shorter holding period.
- Roth IRA conversions are also subject to the five-year rule, but instead of the clock ticking with the first ever deposit, as is the case with Roth IRA contributions, each and every conversion is treated as independent of any others and must be held for five calendar years to avoid taxation of the earnings.
- Most obligations end at death, but not RMDs. They must be taken prior to December 31st in the year of the account owner’s death. If the account owner did not take their RMD, those inheriting the account must ensure that they are processed.
Required Minimum Distribution: planning opportunities
- Reduce taxable income with a Qualified Charitable Distribution (QCD). A QCD is a transfer of funds from an IRA made directly to a qualifying charity. The distribution satisfies RMD requirements and is excluded from taxable income. Several benefits may accrue as a result, including reducing the amount of tax paid on Social Security benefits, reducing Medicare Part B and Part D premiums, increasing the amount of medical or dental expenses that will qualify as an itemized deduction, and avoiding the Net Investment Income Tax.
- Have taxes withheld on distributions to avoid penalties. Taxes are due when income is earned, or distributions are taken. To avoid incurring an underpayment penalty, have taxes withheld directly from the distribution.
- Transfer shares directly to a taxable brokerage account to satisfy your RMDs while keeping your asset allocation intact.
- Identify lagging investments and use those to satisfy your RMD. You may elect to transfer the shares directly to a taxable account if the investments are likely to increase in value.
- Actively employed individuals may defer RMDs by rolling IRA funds into the defined contribution retirement plan sponsored by their current employer. Check with your employer to determine whether the plan will allow rollovers from an IRA. As there is no RMD requirement for Roth IRA owners, the focus here should be on tax-deferred IRAs.
- A Qualified Longevity Annuity can help protect retirees from outliving their assets by providing additional income that begins later in retirement. They also allow for the continued deferral of RMDs- an ancillary benefit for those that do not need the income from the RMD. A note of caution: a longevity annuity should not be used solely to defer RMDs but may work out nicely when a genuine need for the annuity exists.
- Use Roth IRA conversions to reduce RMDs. For those that do not need the income generated from their RMDs, a Roth conversion may be a smart tax planning strategy. Converting IRA accounts to Roth accounts over time, especially in low-income years, can reduce the value of assets that are subject to RMDs, and beneficiaries will receive the funds free of tax, so long as the five-year rule is met.
- Use RMDs to fund 529 college savings accounts. Although the amount of the RMD is fully taxable, contributions to a 529 plan will grow tax-deferred and are not subject to taxation if used for qualified education expenses. Beware, however, of the impact that grandparent-owned 529 plans have on need-based financial aid.
- Avoid RMD on a Roth 401(k) by moving the assets to a Roth IRA. The five-year rule on Roth IRA distributions must be met, so remember to either establish and fund a Roth IRA account well in advance or rollover the Roth 401(k) to a Roth IRA more than five years before the funds will be needed.
- Review your retirement account beneficiary designations regularly. Naming a spouse as the sole beneficiary of a traditional or Roth IRA provides them with the opportunity to treat the proceeds of their deceased spouse’s account as if it were there own. This additional flexibility does not extend to non-spousal beneficiaries or cases where multiple primary beneficiaries are listed.
- Don’t wait until the end of the year to take RMDs. This is especially true for those in poor health, or otherwise contemplating end-of-life care. An RMD must be taken in the year of the account owner’s death, and it may be challenging to posthumously process an RMD in a timely manner when death occurred late in the year.
- Plan early for RMDs by establishing an appropriate balance of tax-deferred, taxable and tax-free accounts. Those nearing retirement with substantial holdings of the publicly-traded stock of their employer should evaluate whether the Net Unrealized Appreciation election is right for them. This election reduces the value of assets subject to RMDs, and is especially beneficial in cases where the cost to acquire to stock was far less than the fair market value.
Planning for required minimum distributions can be relatively straightforward for retirees that rely on regular account distributions to meet their retirement income needs. The amount of the RMD for many may be modest in relation to their total annual distributions, but RMD rules can be tricky and may result in unintended consequences. Complexity enters the fray when distributions are not needed to fund lifestyle expenses, and when there may be multiple potential uses of the funds.
Armed with the rules and an understanding of some common planning pitfalls, planning for RMDs can be seamlessly integrated into your retirement income plan. Diamonds are expensive and so is missing an RMD.
John Male, CFP®, RICP®
The Gassman Financial Group
The Retirement Maven™
9 East 40th Street
New York, NY 10016