When you contribute to a traditional retirement plan the IRS gives you a lofty gift. Not only do you get a tax deduction the year of your contribution, but you get tax deferral on the earnings. Compounded over many years, that can add up handsomely. Unfortunately, Uncle Sam’s generosity doesn’t last forever. Eventually, the IRS wants to make you take some of that money out, so they can tax you. If you don’t follow those rules, the IRS can go from Uncle Sam to Uncle Scrooge quickly.
Penalties for failing to take your required minimum distribution equal 50% of the amount of your required distribution plus ordinary income taxes. Fortunately, the rules surrounding the requirement are not that difficult and there are even strategies you can employ to help reduce your tax liability.
What is the Required Minimum Distribution?
The Required Minimum Distribution (RMD) is the IRS mandated amount of money you must withdraw from traditional IRAs or an employer-sponsored retirement account by December 31st each year once you turn 72. That isn’t a typo, way back in 2020 the Secure Act did away with the half birthday, raising the RMD beginning date from 70.5 to 72.
A special rule is in place for your very first RMD you have until April 1st of the following year. Although, if you delay your first RMD until April, you’ll have to take 2 RMDs your first year. The first by April 1st, the second by December 31st.
How are the RMD amounts calculated?
It comes down to simple math. As long as you are the original account owner, you calculate your RMD by dividing the prior year-end account balance by your life expectancy factor.
The IRS provides lifetime tables reflecting the life expectancy factor that is needed in calculating RMDs. Recent legislation updates the tables to reflect a longer life expectancy starting in 2022.
Two tables are available, one uniform lifetime table and one for joint life expectancy. If your spouse is no more than ten years younger, your RMD is calculated using the uniform lifetime table. Use the joint life expectancy table if your spouse is the only primary beneficiary and greater than ten years younger than you. Your IRA and 401(k) provider should do the calculations for you and let you know towards the beginning of each year what you are required to take.
How do RMDs play into your tax liability?
The IRS taxes RMDs as ordinary income. It is the very reason we have them in the first place. For years the government has given us the gift of deferred tax growth. Once you hit 72, the US Government wants a gift in return. This means withdraws will count toward your taxable income and be taxed at your applicable federal income tax rate. In some areas, RMDs could also be taxed at the state or local level. Fortunately, we are in Florida, and traditional retirement distributions are only subject to federal taxes.
What if I don’t need the money?
If you don’t need the required minimum distribution to sustain your lifestyle, strategies exist to help reduce your taxable required minimum distribution amount.
QCD- QUALIFIED CHARITABLE DISTRIBUTION
For those charitably inclined people, once you turn 70.5, (again not a typo, QCD still falls on the pre-secure act birthday) the IRS allows you to give up to $100,000 annually from your IRA completely tax-free. You do not even have to itemize to get the tax benefit of your charitable gift if your distribution goes directly to the charity, therefore it doesn’t show up on your tax return as income in the first place. The QCD will also satisfy in whole or any portion of your RMD without the tax bite.
STILL WORKING EXCEPTION
Employer-sponsored retirement plans can offer a still-working exception. If you are still working after age 72, you may be able to delay taking your RMD from your company plan until April 1st, following the year you retire. If your plan allows, you can even roll your pre-tax IRA funds into your company plan and delay the RMDs on these funds too.
Qualified Longevity Annuity Contracts (QLAC) are not subject to RMDs until age 85. These products were designed to help with longevity concerns. You can purchase a QLAC with the lesser of 25% of your retirement funds or $135,000. The 25% limit is applied to each employer plan separately but in aggregate to IRAs. QLACs are not for everyone. You should only consider this type of annuity contract if you feel confident you will not need the funds before the beginning of the contractual period when fixed distributions will begin.
ROTH IRA CONVERSIONS
Roth IRAs are not subject to RMDs during your lifetime. While the conversion is a taxable event, you can exchange a one-time tax hit for a lifetime of never having to take an RMD, assuring you avoid the 50% penalty and other potential tax consequences. From age 59.5 and age 72, when the RMD kicks in is the sweet spot for this strategy. If you are not retired, and your income is lower, this may be the time to take taxable IRA distributions to reduce RMDs later.
Each of these strategies has its pros and cons. Not all methods make sense for everyone. And to add insult to injury, the rules pertaining to each strategy can be complex. If you are considering implementing one of these strategies, you should consult with your financial professionals. If you need assistance deciding which of these strategies would work for you, we would love to help. Reach out to us at firstname.lastname@example.org.
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