Most of us are years away from having to seriously consider withdrawing funds from retirement savings to finance our “golden years”. However, for many baby boomers that time is now. As retirement approaches, it is important to remember that at age 70-1/2, you are required to begin taking required minimum distributions (“RMD”) from your Individual Retirement Accounts (“IRA”). There are also rules addressing RMD from employer-sponsored retirement plans. This article looks at the “ins and outs” of RMD.
Required Minimum Distributions are amounts that are required to be withdrawn annually from traditional IRAs and employer-sponsored retirement plans.
The RMD rules were created with several objectives in mind:
- To provide lifetime distributions for the individual and/or a joint life expectancy
- To ensure that some of the funds are taxable distributions in the individual’s lifetime, and
- To ensure that the funds are not just accumulated for deferred taxation to be inherited.
RMDs from an IRA
Individuals with IRAs are required to begin lifetime RMDs from their IRAs at age 70- ½. If this is the first RMD, it can be delayed until April 1st of the year following the year in which the individual reaches age 70-½. If this option is chosen, two RMDs will be required during that calendar year.
If an individual has several IRAs, the December 31st balances may be added together to determine the total RMD for that year. The calculated RMD may be taken from a single IRA or may be split between two or more IRAs.
The RMD amount is determined by applying a life expectancy factor (IRS Uniform Lifetime Table) to the account balance(s) at the end of the previous calendar year. To calculate the distribution:
> Find the appropriate age on the IRS Uniform Lifetime Table
- If the spouse is more than 10 years younger, the Joint Life and Last Survivor Expectancy Table must be used.
> Determine the corresponding factor
> Divide the December 31st balance by this factor
An individual can withdraw more than the minimum amount from their account in any year. If the amount withdrawn is less than the required minimum, they will be subject to a federal penalty. The penalty is 50% of the amount that should have been withdrawn but was not. The penalty is in addition to the individual's federal tax and any state and city income taxes.
Roth IRA owners are not required to take RMDs.
After- Death Distributions from an IRA
IRA death benefits differ from those of an employer sponsored retirement plan in the following ways:
> A nonspouse rollover is not required,
> The decedent’s IRA can be retitled to an inherited IRA without a rollover transaction,
> A spouse can delay distributions until he/she reaches age 70 ½, if desired,
> A nonspouse IRA beneficiary must either
- Begin to receive distributions by December 31st of the year following the decedent’s death or
- Elect to follow the “5-year rule” (see below), if the decedent died before April 1st of the year after he/she reached 70- ½. This does not apply if the RMD-s have already begun.
RMDs from an Employer Sponsored Plan
Qualified retirement plans of an employer, such as 401(k) plans, require the same distributions as IRAs. However, the beginning date requirement may be later than the date for IRAs. In most cases, a RMD from an employer-sponsored plan may be postponed until April 1st of the year after an individual retires or reaches age 70-½, whichever is later, unless the individual is a 5% or greater owner who is sponsoring the plan. No RMD is required if the employee continues to work for the employer (unless the employee is a 5% or greater owner).
The calculation of the RMD from an employer-sponsored plan is the same as for an IRA account.
Required minimum distributions do not qualify for a rollover distribution. The individual must receive a cash distribution. Since these distributions are not rollover-eligible, applicable taxes are not required to be paid at the time of distribution. The tax can be postponed until an income tax return is filed. If an individual requests an amount over and above the RMD, the excess amount is eligible for a rollover within the customary 60 days of the RMD date. However, the income tax on the amount in excess of the required RMD must be deducted from the distribution if that portion has not been stipulated as the rollover option.
If an individual has more than one employer-sponsored plan, the RMD calculation for each is performed separately, and the distributions must be taken from each plan individually.
After- death distributions from an Employer Sponsored Plan
In 2006, legislation was passed that would allow qualified retirement plans to amend their documents to offer a “nonspouse rollover.” Previously, upon the death of a participant, distributions were required to be made to the named beneficiary. Starting in 2007, the beneficiary could make a direct transfer of the funds to an inherited IRA, if the plan allows, or take a distribution. The transfer must be in the name of the decedent for the benefit of the named beneficiary. These funds will be treated as the spousal IRA, and distributions can be deferred until age 70-½. A nonspouse beneficiary cannot roll over a distribution from an employer retirement plan into their IRA but can directly roll the distribution over into an inherited IRA. Both spouse and nonspouse beneficiaries can roll over ("convert") non-Roth distributions from an employer plan into a Roth IRA.
The Five- Year Rule
The five-year rule states:
> The entire account balance must be withdrawn over a five-year period.
> It does NOT require a certain amount be withdrawn each year, or even distributions be taken each of the five years. The entire remaining balance becomes a required distribution in the fifth year.
> If the decedent died prior to age 70-½ and the beneficiary does not start a lifetime payout by the end of the year after death, the five-year rule will apply.
> If the decedent died prior to age 70-½ and the named beneficiary is the estate or a charity, the 5-year rule applies. However, the stretch IRA approach is not viable.
- This concept allows the original IRA beneficiary (the charity) to distribute the assets to specific second, third or more generations of beneficiaries.
- This financial strategy allows the original beneficiary to extend the life of the account balance as well as the tax advantages.
> If the deceased died after starting to receive his/her required minimum distributions, the five-year rule does not apply.
- The beneficiary must take distributions over the longer of his/her own life expectancy or the remaining life expectancy that the deceased would have had.
- If an estate or charity is the named beneficiary, then the estate or charity may take distributions over the remaining life expectancy the deceased would have had.
Depending on personal circumstances, once these distributions have begun it might be prudent to save a little and spend a little. It is important to remember that life expectancy has increased since the time most baby boomers began to save for their golden years.