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How RMDs Affect Your Investment Accounts

Required Minimum Distributions (RMDs) are the amounts the federal government mandates you to withdraw annually from your retirement accounts after turning 70 ½ years of age. After years of practicing the virtue of saving, it may now sound strange to be told to withdraw money. So, what gives? A little history:

In 1974, Congress created the Individual Retirement Account (IRA) under the first federal pension law. The law was intended to prevent companies from relocating to a different state and shortchanging their pensioners. The first IRAs allowed annual contributions of up to $1,500, but were limited to workers that didn’t have employee-sponsored retirement plans. Eventually, Congress allowed all Americans to open IRAs and even roll over other retirement plans such as 401(k)s.

However, Congress overlooked one very large loophole. The government realized it was losing out on billions of dollars in revenue as people rolled over their retirement money into IRAs and left it untouched as it grew tax-deferred. Thus, the only way the government could collect was to patiently wait until IRA owners passed. And from that, the RMD was born.

When RMDs begin – neither a prank nor celebration

Your first RMD must be taken in the year in which you turn 70 ½ years of age. If you are still employed, however, you may be able to delay your first RMD from an active 401(k) until you retire. You may also wait to take your first payment until April 1 of the year following the year in which you must take your first RMD.

Each following year, you must take the RMD by December 31, including the year in which you were paid the first RMD by April 1. Since delaying your first RMD would result in taking two in a single year, it is best to seek the advice of a tax professional to decide when is the right time to take your first RMD.

Investment accounts affected by RMDs

You generally have to take an RMD from any retirement account in which you have made tax-deferred contributions or had tax-deferred earnings. These accounts include:

  • Traditional IRAs
  • SEP IRAs
  • SIMPLE IRAs
  • 401(k), 403(b) and 457 plans
  • Pension and profit sharing plans
  • Inherited beneficiary qualified accounts

Roth IRAs are the exception. You are not required to take RMDs from a Roth IRA during your lifetime.

The RMD penalty

There is a substantial fee for not properly taking your RMD. In the event you fail to withdraw the RMD, withdraw an amount less than the RMD, or withdraw the RMD before the deadline, a 50% excise tax is applied to the amount not withdrawn. Of course, you are always permitted to withdraw more than the RMD, but never less.

How is your RMD calculated?

The RMDs for your retirement plans or IRAs is calculated by dividing the prior December 31 balance of each account by your life expectancy. Your life expectancy is estimated by the IRS under their particular life expectancy tables, which can be found on their website. You may see where this is going: as your life expectancy decreases your RMDs eventually increase. For example, by the time you’re 90, your RMD will be about 10% of account value.

RMDs are configured to distribute the entire interest of the retirement plan account or IRA over the life expectancy of the owner, or the life expectancies of the owner and his or her beneficiary. The function of this arrangement is to prevent people from avoiding taxes by simply building retirement savings tax-deferred and then leaving it all as inheritance. With the implementation of RMDs, the government is able to tax distributions from retirement funds over an owner’s lifetime.

If your spouse is 10 years younger and the sole beneficiary of your IRA, then you qualify to use the joint life and last survivor expectancy table, which lowers your RMD amount. Since your spouse is much younger, your joint life expectancy is then greater. This exception is to help support younger spouses by making the IRA last longer, but to cynical retirees it may appear that the government is providing tax breaks to those that want to marry younger people.

Who does the math and calculates your RMD?

Your account custodians may provide RMD calculations for each of your accounts. Typically, the figure is included in your respective monthly statements for each account. However, it is legally your responsibility to take the correct RMD amount, so any calculations provided should be confirmed with your tax specialist.

Death…

IRA beneficiaries must take distributions of the entire amount within 5 years of the owner’s death, or the beneficiary must take distributions over his or her lifetime beginning no later than one year after the owner’s death. A spouse has some additional options upon inheriting an IRA, and would benefit from the assistance of professional counsel.

…and taxes

RMDs are taxed as ordinary income. While RMD amounts cannot be rolled over into another tax-deferred account, taxes on a distribution can be postponed until you file that year’s income-tax return.

What do you do with an RMD?

If your financial adviser provides monthly withdrawals from your accounts, then the total of those distributions may be enough to cover your RMD. If not, your financial adviser can arrange the appropriate distribution, which presents a great time to also do your annual portfolio rebalancing. Either way, each year you should check with your financial and tax advisers to see if you’ve met your RMD withdrawal requirements or what additional amount you need to take.

In the case that you don’t need your RMD amount for living expenses, you have a variety of options for putting that money to use. One, it can easily be reinvested into a taxable account and potentially generate additional growth in your portfolio.

Or, since the funds have to be withdrawn anyways, they can go toward special lifestyle expenses such as a vacation or gifts for the family. As the oft-repeated Ben Franklin quote goes: “…in this world nothing can be said to be certain, except death and taxes.” The government will get the latter, so you may as well enjoy your money before the former.