What is a Required Minimum Distribution?
A RMD represents the minimum amount that an account holder must withdraw from certain retirement accounts. Anybody with a Traditional IRA, SARSEP, SEP, SIMPLE IRA, or employee-sponsored retirement plan that has reached the age of 70½ is required to take a minimum distribution from their account. RMDs exist, more or less, to force account holders to pay taxes. With a deferred-tax account like a Traditional IRA the account holder contributes pre-tax income to the account, which then grows tax-free over time.
Lest you thought Uncle Sam was going to let that money go untaxed forever, the RMD is a way for the government to finally tax you on this money. The rule states that once you turn 70½ you must take a RMD by April 1st of the following year, at which time you will pay tax on this distribution. For each subsequent year you must take the distribution by December 31st. Forget to take it and you could be subject to a large 50% penalty, calculated as 50% of the RMD amount. Ouch!
Also keep in mind that if you take your first RMD in the following year before the April deadline, rather than by December 31st of the year in which you turn 70½, you will end up taking two RMDs in one year. This may or may not be something you want to do – so be sure to go over this with your advisor and/or tax professional.
How are RMDs calculated?
The amount you’ll be required to take is different for everybody, but it’s generally determined by just two things: 1) the value of your IRA account at the end of the previous year, and 2) your age, which determines the RMD divisor per the IRS table. The RMD calculation looks like this:
|RMD =||Account Value (end of previous year)|
|Divisor (determined by your age)|
For example, if you are 75 years old (corresponding with a divisor of 22.9) and last year your account ended with a value of $200,000 then your RMD for this year would be calculated as follows:
Most major custodians will calculate this value for you, so it’s unlikely you’ll have to pull out your calculator, but it’s good to know where the number is coming from. Keep in mind that as you get older the divisor decreases, meaning your RMD will increase, assuming a constant or growing account value.
Avoiding the 50% Penalty
The 50% penalty for not taking a RMD is one of the more severe financial penalties out there, but avoiding it should be relatively easy. One of the easier options is to simply set up a recurring distribution with your custodian for whatever frequency works best for you, perhaps monthly or quarterly. We can work with you on setting this up and make sure you’re distributions are taking place.
What if You Don’t Need the Income?
As we mentioned at the beginning of the article, this is a Required Minimum Distribution, so unless you want to give your assets away to the government you don’t really have the option not to take it. But just because you have to take it doesn’t mean it just has to sit in your bank account. If you have additional revenue sources (wages, social security, other investment income, etc.) and therefore don’t need your RMD for living expenses you have plenty of options. A lot of clients in this situation will simply take their RMD and transfer it directly into a taxable investment account where it can then be reinvested based on your current needs. This is something we can work with you on as well.
Before we wrap up let’s take a look at a unique account with a little quirk that you should be aware of.
While we’ve focused exclusively on IRAs set up by the original account holder, there is a special circumstance that bears mentioning: if you become the owner of an Inherited IRA it is highly recommended that you contact your investment advisor and/or tax professional. These accounts generally require the inheritor to start taking annual distributions even if they have not reached the age of 70½, so your advisor can help you understand the requirements and make sure you avoid any unnecessary penalties.
While RMDs may seem intimidating it really comes down to just two questions: 1) do you have a Traditional IRA, SARSEP, SEP, SIMPLE IRA, or employee-sponsored retirement plan? and 2) are you at least 70½ years old? If you answer yes to both of these, or are unsure of the first question, then you may want to consult your advisor to confirm that you are setup for your Required Minimum Distribution. And remember, if you inherit an IRA from a relative you’ll want to contact your advisor immediately to make sure you understand the requirements.
Elliott M. Holden, CFA