What are Required Minimum Distributions?
A Required Minimum Distribution (RMD) is the minimum amount that is withdrawn each year from an employer-sponsored retirement plan or IRA after the age of 72. An exception to this is the Roth IRA, which does not require withdrawals until after the account owner’s death. Funds withdrawn from a retirement account as RMD are taxed at regular rates. Non-withdrawal of RMDs may result in a 50% excise tax penalty, meaning up to 50% of your distribution amount may be withheld as tax.
Basics of Required Minimum Distributions
Required minimum distributions prevent retirement account holders from holding onto their funds forever and avoid having to pay taxes on capital gains incurred during their lifetime. The distributions also serve as an important source of income for individuals in their retirement years. According to data from the IRS, only 20% of Americans take the minimum amount of distributions from retirement amounts. The remaining 80% use retirement account distributions for expenses and as income.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 raised the minimum age for taking distributions to 72 from 70.5 years earlier. Those who turned 70.5 years in 2019 were still required to take their first distributions by April 1, 2020.
The Coronavirus Aid, Relief, and Economic Security Act (CARES) suspended distributions from retirement plans for a year in response to the market crash that occurred at the start of the pandemic. The crash depleted retirement account balances, increasing the share of distributions as part of the overall account. RMDs have been reinstated in 2021 and retirement account owners can either withdraw their funds up to the end of 2021 or until April 2022.
There are two important dates for RMD withdrawals: April 1 and December 31. Depending on your birth date and tax priorities, you can make withdrawals by either date. For example, if John turns 72 on August 1, 2020, then he can make his RMD withdrawal in Sep. 2020, and include it in his 2020 tax return instead of the 2021 one. Distributions can be taken as a lump sum, in one withdrawal, or they can be staggered as monthly or quarterly payments.
How to Calculate Required Minimum Distributions
RMDs are calculated based on the retirement account balance of the previous year. That balance is divided by the IRS Uniform Lifetime Table that lists the “Lifetime Expectancy Factor” for an individual. Actuarial calculations based on several variables, including average life expectancy and medical costs, are used to determine the factor. The Uniform Lifetime Table is one of the three used by the IRS for retirement account calculations. The others are the Joint Lifetime and Last Survivor Expectancy Table and the Single Life Expectancy Table.
Suppose the balance of your SEP IRA account at the end of a given year is $500,000 and you are 75-years-old. The life expectancy factor from Uniform Lifetime Table for someone your age is 22.9. Therefore, your RMD for the following year is 500,000 ÷ 22.9 = $21,834. Note that this income will be taxed at the prevailing federal, state, and local tax rates for that year. Any additional withdrawals beyond $21,834 will result in a corresponding increase of your tax liabilities.
The process to calculate RMDs differs slightly, if your spouse is the only primary beneficiary of the retirement account and is more than ten years younger than you. In that case, you will use the IRS Joint Life Expectancy Table to calculate the Life Expectancy Factor. Using the above example, if your spouse was 62 and was the only primary beneficiary of your account, then the RMD is equal to 500,000 ÷ 25 = $20,000.
RMDs for multiple IRAs must be calculated separately for each account.
Inheritance IRA Calculations
A special case of required minimum distributions (RMDs) is that for Inherited IRAs. Distributions for inherited retirement accounts vary depending on the date of death and relationship of account beneficiaries with the deceased.
If the IRA account holder died after Dec. 31, 2019, the rules established by the SECURE Act apply. The act defines different types of beneficiary – eligible designated, designated, and non-designated – and benefits differ based on the type of beneficiary. Eligible designated beneficiaries have the option of using a 10-year period to withdraw all assets from the account or choosing to continue distribution based on the schedule and frequency of the deceased for the beneficiary’s lifetime. Designated beneficiaries must withdraw all assets, regardless of distribution amounts and frequency, from the account by the end of the 10th year. If assets remain in the account after Dec. 31st of the 10th year, then the beneficiary may be subject to a penalty. Non-designated beneficiaries must exhaust all assets in 5 years. This is known as a 5-year rule and it works on the same principles as a 10-year rule.
If the IRA account holder died before Jan 1, 2020, then the beneficiary, if they are a spouse, have the option of choosing when to begin taking the distributions. If they are not a spouse, then they must take the distributions per their own life expectancy and the same schedule as that of the deceased.
The IRS Publication 590-B provides comprehensive documentation about the charges and penalties accruing from IRA withdrawals. It is always a good idea to consult the publication to gain an understanding of the process and associated costs.
Strategies for Minimizing or Eliminating RMDs
As the RMDs from your account increase, they can run up quite a tax bill because they are treated as ordinary income by the IRS for tax purposes. For example, if you postpone distributions from one year to the next tax year, then you are liable for the sum of both distributions in one year. You can adopt strategies to minimize or eliminate RMDs completely and thereby reduce your tax liabilities. Three such strategies are outlined below.
- Transfer Funds to a Roth IRA Account: You can transfer remaining funds from your existing retirement account to a Roth IRA account, which does not tax distributions because investments into the account are made with after-tax income. The caveat to this transfer is that the Roth IRA account must have been open for five years or more and you must bear the expenses for a Roth conversion. This can be an expensive strategy, if there has been a substantial appreciation of funds in your account. That increase will have to be reported as income during the conversion process and you are still liable for taxes on it. It is always a good idea to consult a lawyer or tax attorney before adopting this strategy.
- Keeping Yourself Employed After 72: Individuals who are still working after the age of 72 and do not own more than 5% of a company are not required to take RMDs. The caveat to this rule is that you are still on the hook for 401(k) account distributions from a previous employer, if you have kept them in a separate account.
- Making QCD Donations: Qualified Charitable Donations (QCD), which reduce the overall income for account holders, were instituted in 2015. Under this rule, your contributions to a qualified charity, one that is vetted and defined as such by the IRS, can be deducted from your overall income. Such donations can move you from a higher tax bracket into a lower rung and reduce your overall tax liabilities.