Most of us stop keeping track of our “half birthdays” by the time we turn 10. But if you ask any kindergartner how old he or she is, you are likely to be told, “I’m not five … I’m five-and-a-half!”
It turns out that kids are not the only ones who keep track of age in half-year increments. The folks at the Internal Revenue Service are very interested in when you turn age 70 ½ because that is the year when you have to start taking distributions from your IRA, 401(k), or other tax-advantaged retirement accounts.
There are stiff penalties for failing to take the required minimum distributions (RMDs), so it is important to understand the rules for how RMDs work.
Why do RMDs exist?
RMDs exist because the federal government wants to make sure that you use the tax-deferred money that you set aside in your retirement accounts when you are actually in retirement. Without RMDs, people who had other sources of retirement income could simply leave their retirement assets untouched and allow the advantages of tax-deferred growth to continue compounding throughout the account owner’s life.
When do RMDs start?
Starting in the year that you turn age 70 ½, you are required to take distributions of at least the IRS-mandated amount from your tax-advantaged retirement accounts.
Even if you have already started taking distributions well before turning age 70 ½, the RMD rules still apply.
For the first year that you are required to take a distribution, you have until April 1 of the following year to take the distribution. (Think of the three-month grace period as the half-birthday present that the IRS gives you for turning 70 ½.) But after that first year, the deadline for taking the distribution is December 31 each year. For example, if you reached the halfway point between your 70th and 71st birthdays on September 30, 2015, you would have until April 1, 2016 to take the distribution. But you would have to take your second RMD by December 31, 2016.
If the account owner dies before reaching age 70 ½, then a different set of rules for RMDs apply to the account’s beneficiary.
What types of accounts do RMDs apply to?
The RMD rules generally apply to accounts where the government gave you some sort of up-front tax benefit to encourage you to save for retirement. This includes individual accounts such as IRAs, SEP IRAs, and SIMPLE IRAs, as well as employer-sponsored plans such as 401(k), 403(b), and 457(b) plans. The RMD rules, however, do not apply to Roth IRAs (more on that below).
If you have more than one of these accounts, the amount of your annual RMD will be based on the cumulative value of these accounts.
Why don’t RMDs apply to Roth IRAs?
It is important to note that RMDs do not apply to Roth IRAs. This is because the account owner does not receive an up-front tax deduction when making a Roth IRA contribution.
Because qualified contributions to a Roth IRA are not subject to RMD rules, the assets in the account can continue growing tax-free throughout the account owner’s life. This is one of the primary reasons why, under the right circumstances, Roth IRAs can be effective tools for transferring wealth to younger generations. Please contact us if you would like to learn more about how Roth IRAs work or the rules for converting a traditional IRA to a Roth IRA.
How are RMDs taxed?
Distributions from the accounts listed above, except for Roth IRAs, are generally taxed as ordinary income.
What are the penalties for not complying with RMDs?
There is a hefty penalty for not taking the full RMD amount or for not taking the distribution by the deadline. The difference between the amount that you were required to take as a distribution and the amount that you actually took is taxed at 50%. For example, if your RMD for 2015 was $1,000 but the distribution you took in 2015 was only $250, the $750 shortfall would be taxed at 50%.
How are RMDs calculated?
The RMD amount for a given year is determined by essentially taking a percentage of the account balance at the end of the previous year. The RMD percentage starts at approximately 3.7% in the year that you turn 70 ½ and increases gradually each year after that. By the time the account owner has reached age 85, for example, the percentage has increased to approximately 6.8%; by age 100 the percentage has increased to 15.9%.
To calculate the actual dollar amount of your RMD for a given year, you divide the balance in your account at the end of the previous year by the “distribution period” corresponding with your age at the end of the current year. See the table below with the distribution periods for ages 70 and greater. (If the account owner’s spouse is the sole beneficiary of the account and is more than 10 years younger than the account owner, then a different set of distribution periods apply.)
For example, let’s assume that John will reach the halfway point between his 70th and 71st birthdays on September 30 of this year. At the beginning of the year, the balance of John’s IRA was $100,000. This means that John’s RMD for the year would be $3,650 ($100,000 divided by 27.4).
|Age at end of year||Distribution period||Distribution %|
Source: Internal Revenue Service – IRA Required Minimum Distribution Worksheet
For more information about RMDs and how they are calculated, including the distribution period table for situations where the spouse is more than 10 years younger than the account owner, please visit the IRS’s “Retirement Plan FAQs Regarding Required Minimum Distributions.”
What do RMDs mean for you?
At The Retirement Network, we are committed to helping our clients navigate RMDs and other rules related to their retirement accounts. For our clients, we will contact you to let you know what your RMD amount is and generate a strategy for generating the distributions. If you have any questions about RMDs and how they affect your retirement plans, we are always here to help.