Understanding RMDs Can Help You Save

One factor people often overlook in retirement is the tax impli­cation of Required Minimum Distri­b­u­tions (RMDs). According to a recent analysis, retirees could realize as much as $650 billion in tax savings each year with better retirement income planning.¹

Financial advisers special­izing in retirement planning under­stand that RMD planning is essential to minimizing taxes in retirement. RMDs have some quirky rules, and mistakes are common—so common, in fact, that the IRS created Form 5329 solely for taxpayers to report them.

Under­standing RMD rules can lead to smarter decisions.

So, how much do you know about RMDs? Test your knowledge of the basics with this simple quiz. Answers can be found at the end of the article along with links to detailed explanations.

1. What infor­mation does an individual need to determine their RMD from an IRA account? 
   1. The RMD is based on the account value and the taxpayer’s current income tax bracket.
   2. The RMD is based on the taxpayer’s current income tax bracket and life expectancy.
   3. The RMD is based on the account value and the taxpayer’s life expectancy.
      
2. When does an IRA owner need to begin taking RMDs? 
   1. December 31st of the year they turn age 70 1/2.
   2. April 1st of the year after they turn age 73.
   3. April 15th of the year after they turn age 72.
      
3. Annual RMD amounts cannot be converted to a Roth IRA. 
   1. True
   2. False
      
4. If an individual owns more than one IRA, how are RMDs calculated? 
   1. The annual RMD must be calcu­lated separately for each IRA, but the total may be taken from any one or more of the IRAs.
   2. The annual RMD must be calcu­lated separately for each IRA and the total withdrawn equally from all accounts.
   3. The annual RMD must be calcu­lated and withdrawn separately for each IRA.
      
5. What is the amount of the tax penalty assessed by the IRS when an individual fails to take their RMD? 
   1. 15%
   2. 25%
   3. 50%
      
6. The tax penalty may be waived if the shortfall is due to reasonable error and reasonable steps are being taken to remedy it. 
   1. True
   2. False
      
7. Which of the following rules applies to the “Still Working” provision, which postpones RMDs from a 401(k) or 430(b) employer plan? 
   1. The employee must be working full-time.
   2. The provision is optional, and the employer plan must adopt it for an employee to defer their RMD.
   3. Employees with multiple 401(k) accounts are eligible to defer RMDs from all accounts if they qualify for the provision.
      
8. No special rules or excep­tions apply to an IRA inherited by a surviving spouse. 
   1. True
   2. False
      
9. Assuming the original account owner had not begun taking RMDs, when must a non-eligible desig­nated benefi­ciary begin taking RMDs from an inherited IRA? 
   1. The account must be emptied by December 31st of the 10th year following the account owner’s year of death.
   2. December 31st of the year following the account owner’s year of death.
   3. April 1st of the following year, the benefi­ciary reaches age 72.
      
10. Qualified Chari­table Distri­b­u­tions (QCDs) allow IRA owners to gift IRA funds directly to charity without including them in income. How old does an IRA owner need to be to make a QCD? 
    1. There are no age require­ments for QCDs.
    2. 70 1/2.
    3. 72.

How did you do? Were you surprised by any of the answers?

When helping clients create a tax-efficient retirement, we consider the cash flow they need to fund their lifestyle and the potential sources of that income. Sources such as Roth IRAs provide tax-free income, and tax-deferred accounts like IRAs and 401(k)s provide taxable income.

RMDs have tax impli­ca­tions because retirees must make withdrawals or face severe tax conse­quences. And drawing an RMD can itself have unintended tax impacts. You might be pushed into a higher tax bracket, be required to pay more tax on Social Security benefits or become subject to the 3.8% Medicare Surtax.

We always recommend retirees begin RMD planning before they turn 73, and one strategy to avoid RMDs is to convert some or all retirement accounts to a Roth IRA. Converting an IRA to a Roth creates a taxable event on any amount of pretax money in the IRA. The tax is paid in the year of conversion, and all earnings grow tax-free from that point on (provided rules are followed). When consid­ering this strategy, it is best to run careful projec­tions to make sure the long-term benefits outweigh the upfront conversion tax.

Tax-efficient retirement planning can be overwhelming, and there are a lot of compli­cated factors to hold in balance. The best strategy depends on your overall pool of investable assets, pension, Social Security income, and other income sources. Tax projec­tions are a great place to start, but tax laws and financial markets change, which is why we recommend updating projec­tions regularly to minimize tax.

When devel­oping a tax-efficient strategy for taking RMDs, it is best to stay focused on the big picture: Make sure taxes are part of the plan but not driving it.

Insights:

• A required minimum distri­b­ution (RMD) is the amount of money that must be withdrawn from a qualified retirement account at a specified age.
• Withdrawals from retirement accounts are generally taxed as ordinary income.
• Roth IRAs do not have minimum distri­b­ution requirements.

Quiz answers:

1. c) An RMD is based on the account value and the taxpayer’s life expectancy.
2. b) April 1st of the year after they turn age 73.
3. a) True.
4. a) The annual RMD must be calcu­lated separately for each IRA, but the total may be taken from any one or more of the IRAs.
5. b) 25%. However, the penalty could be as low as 10% if corrected by the taxpayer in a “timely manner.”
6. a) True.
7. b) The provision is optional, and the employer plan must adopt it for an employee to defer their RMD.
8. b) False.
9. a) The account must be emptied by December 31st of the 10th year following the account owner’s year of death.
10. b) 70 ½.