Taxpayers reaching age 73 this year will discover the downside of tax deferral. A portion of the funds they set aside in retirement accounts (to avoid tax while working) will start to become taxable each year. It is time to pay the piper, or the IRS in this case. Required minimum distributions (RMDs)—the amount of taxable income that must be withdrawn from retirement plans annually—are about to begin
RMDs have some quirky rules, and mistakes are common. So common, in fact, that the IRS created Form 5329 for taxpayers to report RMD mistakes. Let’s start by reviewing the basics:
- A taxpayer’s first RMD must be taken by April 1st following the year they turn age 73. The RMD is due by the end of each year after that.
- To calculate the amount of the RMD, a taxpayer takes the balance of all IRA accounts on December 31st of the prior year and divides it by their life expectancy (which can be found in the IRS’s Uniform Lifetime Table)
- If the taxpayer’s spouse is the sole beneficiary and is more than 10 years younger, they will use the Joint Life and Last Survivor Expectancy Table.
That’s all there is to it. Calculate the right amount and withdraw it by the due date. However, missing the due date or not taking enough funds could trigger a 25% tax penalty for any shortfall.
The following questions cover a few of the common mistakes.
What if I have more than one IRA?
Owners of multiple IRA accounts can aggregate them to calculate the RMD, and the withdrawal would only need to come from one of the accounts. Traditional IRAs, SEP IRAs, and SIMPLE IRAs can be aggregated. Inherited IRAs are separate and should not be included when aggregating retirement accounts. Roth IRAs are not subject to RMDs.
Are employer plans–401(k)s, 403(b)s, etc.—subject to RMDs?
Employer plans are subject to RMDs, and the RMD cannot be satisfied by taking from an IRA. Taxpayers still working get a pass at age 73 as long as they do not own more than 5% of the company. After they turn 73, the due date for the first RMD from their company plan will be April 1st of the year after they separate from service.
A working taxpayer is still required to take RMDs from their IRAs. A common mistake happens when taxpayers assume their IRA qualifies for the same exception as their 401(k).
There is another exception, however, for taxpayers who participated in a 403(b) plan before 1987. For these plans, the RMD for contributions made before 1987 are not required until age 75. Taxpayers should have a statement showing the plan balance on December 31, 1986, as documentation to prove the exemption. Any funds contributed on or after January 1, 1987, and the earnings on the pre-1987 balance are subject to the age 72 due date, making this a complicated calculation to track.
The standard April 1st RMD applies to all other amounts in the plan, including earnings on the pre-1987 balance. Due to attrition, this exception applies to fewer people each year, but advisers should still know about it.
Taxpayers with more than one employer plan will need to calculate the RMD for each plan and take the withdrawal from that particular plan. The exception to this rule occurs when a taxpayer has more than one 403(b) account. The account owner can aggregate all their 403(b) account balances and take the RMD from just one of the accounts.
How is the RMD determined for an inherited IRA?
RMDs are required from traditional IRAs and Roth IRAs inherited. RMDs must generally begin by December 31st of the year after the original owner’s death and be taken by the end of each future year. There are special exceptions for spouses who inherit these accounts. The 25% tax penalty applies to missed RMDs from inherited IRAs and Roth IRAs even though Roth IRAs are tax-free. When there are multiple beneficiaries, the RMD is based on the oldest beneficiary’s age, unless the inherited IRA was split by the end of the year of death.
A properly titled inherited IRA should contain the name of the deceased IRA owner and identify the account as a beneficiary IRA. See 7 Steps to Take When You Inherit an IRA for more on inherited IRAs and Roth IRAs.
For IRA owners who were past age 73 in the year of death, the RMD must be taken by the beneficiary. The beneficiary takes the year-of-death RMD and reports the income on their tax return. It does not go on the decedent’s final income tax return or their estate income tax return. The year-of-death RMD is based on the decedent’s distribution had they lived.
The 10% early withdrawal penalty for those under age 59 ½ never applies to distributions from inherited traditional or Roth IRAs. Distributions due to death are one of 10 penalty exemptions for early distributions. Talk to a knowledgeable adviser, preferably an experienced retirement adviser, if you receive notice that you will be inheriting an IRA. There may be tax minimization strategies you can implement.
- Failure to take RMDs on time can result in a 25% tax penalty
- IRAs can be aggregated, and the RMD can be satisfied from just one of the accounts.
- Stretch IRA rules no longer apply when the IRA owner dies after December 31, 2019.
Originally Posted February 25th, 2016