IRAs are a great tool for building up a retirement nest egg. With traditional IRAs, you get to make contributions that are either pre-tax or post-tax, and then let the money grow until you retire, deferring tax on the pre-tax contributions and the growth.
While it may seem that Uncle Sam is generous in allowing this tax deferral, keep in mind that he will get his share one way or another. In fact, to ensure that the federal government gets their piece, the IRS mandates what are called Required Minimum Distributions, otherwise known as RMDs (Roth IRAs are not subject to RMDs).
Required Minimum Distributions
RMDs can be a bit tricky, and they can cause some problems for those who do not plan for them. If RMDs are not done correctly, an IRA owner could be subject to a 50% tax penalty, and if RMDs are not properly incorporated into an overall retirement income plan, they could result in unnecessarily high income tax in retirement.
Here is what the IRS says about RMDs:
- You cannot keep retirement funds in your account indefinitely. You generally have to start taking withdrawals from your IRA, SIMPLE IRA, SEP IRA, or retirement plan account when you reach age 70½. Roth IRAs do not require withdrawals until after the death of the owner.
- Your required minimum distribution is the minimum amount you must withdraw from your account each year.
So, you have to begin taking your RMDs in the year you turn 70½ and they are calculated by dividing your traditional IRA or retirement plan account balance by a life expectancy factor specified in IRS tables. Your account balance is usually calculated as of December 31 of the year preceding the calendar year for which the distribution is required to be made. Confused? You are not alone. Here is an example:
You have a traditional IRA and your 70th birthday is November 1, 2016. Therefore, you reach age 70½ in 2017. Because you turn 70½ in 2017, you must take an RMD for 2017 from your IRA. This distribution (your first RMD) must be taken no later than April 1, 2018. (Please note: this extra three-month period for taking your distribution occurs only for your first RMD.) In calculating this RMD, you must use the value of your IRA as of December 31, 2016. Additionally, you must take an RMD for 2018 no later than December 31, 2018 and it will be based on the value of your IRA on December 31, 2017. So, if you deferred your first RMD until 2018 (before April 1), you would be taking two RMDs in 2018 - one for 2017 (the year you turned 70½) and one for 2018, both of which would be calculated differently.
For most taxpayers, calculating RMDs is straightforward for each subsequent calendar year after the first distribution. Simply divide your account balance as of December 31 of the prior calendar year by a factor called a “distribution period,” determined under the Uniform Lifetime Table, using your attained age in that calendar year.
The following Uniform Lifetime Table applies to:
- Unmarried owners
- Married owners whose spouse is not more than 10 years younger
- Married owners whose spouse is not the sole beneficiary
However, RMD calculations are not always so straightforward, especially with spouses of significantly different ages, an inherited IRA, or if you have been divorced. In these cases, there are rules that may change how you calculate your RMD. Also, if you have multiple IRAs or retirement plan accounts, RMD calculations and distribution methods may vary.
In IRAs, Uncle Sam certainly provides us a great tool for retirement savings with the deferral of taxes on income (in some cases) and on the growth of our investments. However, he does require that we pay up, and he doesn’t take kindly to those who don’t follow his rules (a 50% penalty). Further, some of the leeway that is provided in the first RMD can complicate an IRA holder’s tax situation. It is important to take timely and accurate RMDs.
GET HELP WITH YOUR RMDS
If you are facing your first RMD, have inherited an IRA, or have been divorced, and are unsure how it could impact you, please request a Q&A session with Retirement Advisors of America to discuss how RMDs could affect your unique retirement income plan.
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