The IRS incentivizes investors to make tax deductible contributions to a number of different tax-deferred accounts such as an IRA, 401(k), SEP IRA, SIMPLE IRA or 403(b). For many investors this is their primary way of saving for retirement. The IRS allows the tax deduction on initial contribution and the continuous tax-free compounding of growth until distributions are taken or required. Any withdrawals in retirement are taxed as ordinary income for federal and state taxes if applicable. If you initiate a withdrawal prior to age 59 ½, not only will you pay taxes on the distribution, but you will also have to a pay a 10% early withdrawal penalty.
When do I have to start Required Minimum Distributions (RMDs)?
Once you reach age 70 ½, the IRS requires that you begin taking a mandatory distribution on a yearly basis from your tax deferred account. You didn’t think the IRS would let you keep deferring taxes forever did you? If it’s the first year of distribution, you can take the withdrawal by April 1st of the following year after you turn 70 ½, but you would have to take two distributions in this second year. Most investors take the distribution in the initial year so they do not have as large of a taxable distribution by waiting until the second year to start taking RMDs.
How do I determine the amount of my RMD?
The IRS has a life expectancy table which I have reproduced below. (Note, this is one of three types of life expectancy tables. The other two tables relate to inherited IRAs and if you have a spouse more than 10 years younger than you. For illustration purposes, the table below will apply to most investor’s financial situations. However, you should consult your CPA and fee-only financial planner to help you with the RMD calculation). The amount of your RMD is based on dividing your previous year’s 12/31 account balance by the “Divisor” in the table related to your age. For example, let’s assume you are turning 70 ½ in 2016. You would take your IRA or other tax-deferred account balance as of 12/31 of the prior year, 2015 in this case. Let’s assume it was $100,000. You then divide this by the “Divisor” factor of 27.4, which equals an RMD of $3,649.64.
|Age||Divisor||% Withdrawal||Age||Divisor||% Withdrawal|
Source: IRS Publication 590
For fun I added a third column which converts the “Divisor” into a “% Withdrawal” to better show the impact of the RMD increasing over time. At age 70 ½, the “Divisor” requires a relatively small distribution, equivalent to approximately 3.6% of the tax deferred account balance. But as you see above, the “Divisor” goes up each year of age thereby increasing the withdrawal rate as a percentage each successive year. By age 80, the “Divisor” is 18.7, equating to a withdrawal rate of 5.3%, and at age 90, the “Divisor” is 11.4, equating to a withdrawal rate of 8.8%. The withdrawal rate continues to increase with age as the IRS wants to make sure it is receiving tax dollars in exchange for all those years of tax deferral!
Should I take the distribution all at once?
You have options for the withdrawal. It can be taken in a lump sum or over a period of time within the year of each RMD. If the required amount is relatively large, you could pro-rate the distribution and withdraw funds monthly over the course of a year. Since most people pay their bills monthly, this may help to provide a consistent income stream on a month-to-month basis and allows the funds to remain invested in your IRA/tax deferred account and potentially grow for as long as possible.
What if I have more than one IRA or tax deferred account?
Typically each separate account will require an RMD. There are situations where you can take one distribution from one IRA to cover for multiple IRAs and meet the RMD requirement for all of your IRAs. However, you should consult with a fee-only financial advisor and/or your CPA to make sure you are taking the appropriate RMD if you have multiple tax deferred accounts.
What if I forget to take my RMD withdrawal?
The IRS imposes a 50% penalty on any RMDs not taken. This is the stiffest of any IRS penalties. This penalty is in addition to any ordinary income taxes you will owe on the distribution. Most investment custodians do a good job reminding their investors of the annual RMD. However, if you do happen to miss an RMD, you will want to consult your CPA as special forms need to be filled out and submitted to the IRS when catching up on any missed RMDs.
What if my income needs in retirement are greater than the RMD?
You can always withdraw more than what is required by the RMD. A higher withdrawal amount will generate more ordinary income taxes. If you have taxable assets, you may be able to take a portion of withdrawal from this source to complement the RMD as taxable assets are typically taxed at more favorable capital gains rates versus ordinary income tax rates.
Every investor has a unique tax situation. Your comprehensive financial planner can coordinate and recommend the best combination of withdrawal amounts between your tax-deferred and taxable accounts, in addition to coordinating this with your Social Security benefits, pensions, deferred compensation, rental income, or any other sources of income you may have in retirement. Your fee-only certified financial planner can also ensure you are on track for a successful retirement.