Required Minimum Distributions — A Milestone Not to Be Ignored

The tax deferral you enjoy in your IRA or 401(k) cannot go on forever. The IRS ensures this money will eventually get taxed by requiring you to make withdrawals over your lifetime, beginning at age 70½. Making the withdrawals is simple; however, some of the rules and exceptions can be tricky, and making a mistake can cost you a bundle. The IRS levies a hefty 50% penalty on the portion of the Required Minimum Distribution (RMD) that is not withdrawn on time. At BWFA, we help clients understand their RMDs, plan for the tax consequences, and avoid any penalties.

There are two groups of people who need to make RMDs: (1) those age 70½ and older, and (2) those who have inherited an IRA or another type of retirement account.

The RMD is fairly easy to calculate. You take the total value of all your retirement accounts on the last day of the prior year, and then divide that value by your life expectancy as defined by the IRS Uniform Life Expectancy Table. The result is your RMD for the current year. For example, if your IRA was worth $1,000,000 on December 31, 2006, and you are 71 years old, you divide $1,000,000 by your life expectancy, which is 26.5 years. Your RMD for 2007 is $37,736. The calculations are a little different for married persons with a spouse who is more than 10 years younger than they are, and for people who inherit an IRA. In these cases, you use different life expectancy tables.

There are some exceptions to these rules. If you are still working at age 70½, you can defer making RMDs from your employer’s plan until you retire. Money held in a Roth IRA is not subject to RMD rules. Finally, a spouse who inherits an IRA can roll the money into his or her own IRA and delay RMDs until he or she is 70½.

Common Questions and Planning Opportunities

  1. Which is the best year to take my first distribution?
    Your first RMD must be taken no later than April 1st of the year following the year you turn 70½. Every year thereafter, you have to make your withdrawal by December 31st of that year. Therefore, if you delay your first distribution until the following year, you will end up having to take two withdrawals in the second year. Making two withdrawals in one year might push your income into a higher tax rate and increase your overall taxes.

    It makes sense to delay your first withdrawal if the two withdrawals in the subsequent year will not push your income into a higher tax rate. However, in most cases, our clients’ taxes will be lower if they do not delay their first RMD and take it in the year in which they turn 70½.

  2. Does naming a young beneficiary lower your RMD?
    No. Because of tax law changes, you no longer consider the age of the beneficiary when calculating your RMD.

    One exception to this rule is if your spouse is more than 10 years younger than you. In this situation you use a joint life expectancy table which effectively reduces the amount you have to withdraw.

  3. Can you convert your RMDs into a Roth IRA?
    No. Any amount you convert to a Roth IRA does not count toward your RMD for that year. However, making Roth conversions from your IRA will lower future RMDs for yourself and your heirs, since Roths are not subject to RMDs.

    The downside of Roth conversions is that you have to pay the taxes now on any money you convert. It takes careful analysis to determine whether this strategy will actually reduce your overall taxes. We find that it works best for clients who shift between higher and lower tax rates from year to year.

  4. Can you work for yourself after age 70½ and delay making the RMDs?
    No. Business owners and sole proprietors cannot delay RMDs from their own retirement accounts. However, if you are an employee who owns less than 5% of the business, you can delay RMDs from your current employer’s retirement plan until you stop working. You would still have to make RMDs from any IRA and former employer retirement accounts you may have.

Even though the calculation of your RMD is simple, there are many issues to consider as you approach this milestone. Careful planning can benefit you by lowering taxes and avoiding penalties. We would be happy to speak with you about your RMDs and the services we provide to help you handle them correctly.