Required minimum distributions are one piece of the retirement puzzle that could hardly be more puzzling. What’s scary is that the stakes are high: If you take an IRA distribution for a calendar year that’s less than what the IRS requires, you’ll be hit with a tax penalty of 50% of the shortfall (unless you can persuade the IRS to waive it for “reasonable cause”).
Some background: Required minimum distributions, or RMDs for short, are annual withdrawals people generally are forced to take from tax-deferred retirement accounts, such as IRAs, once they reach age 70½. The money people save in those accounts has grown tax-free, and now Uncle Sam wants to start collecting his share.
One thing people might not realize is that IRAs aren’t the only accounts subject to RMDs. If you’ve got a 401(k) or 403(b) plan, in most cases you will be forced to start taking distributions when the time comes as well.
So, how do you calculate your RMD, how can inheritance rules complicate them and what are some best practices? Here is a summary of the basic RMD rules:
During the Lifetime of the IRA Owner
For a “traditional” (i.e., non-Roth) IRA owner, the first RMD during the owner’s lifetime must occur by April 1 of the year after the calendar year during which the owner reaches age 70½ (also called the Required Beginning Date). For each subsequent calendar year, the distribution must be made by Dec. 31 of that year. Essentially, what that means is:
- If you turn 70 between Jan. 1 and June 30 in 2017, then your first RMD would have to be taken no later than April 1, 2018. Your second RMD would come due by Dec. 31, 2018: Because you waited, you’d end up having to take two distributions in the same year, which, of course, will increase taxable income for that year.
- If you turn 70 between July 1 and Dec. 31 in 2017, then your first RMD would have to be taken no later than April 1, 2019, and your second would come due by Dec. 31, 2019.
The RMD amount is based on an IRS table (Table III of Appendix B, IRS Publication 590-B), using the joint life expectancy of the owner and a 10-year younger beneficiary (regardless of the actual age of any beneficiary or even in the absence of a named beneficiary). However, if the sole beneficiary is the owner’s spouse, and the spouse is more than 10 years younger than the owner, the RMD amount is based on another IRS table (Table II of Appendix B), using the actual joint life expectancy of the owner and spouse.
Each calendar year, the RMD is calculated using the IRA account balance from the prior Dec. 31, divided by the appropriate factor on the IRS table. This includes the calendar year of death, so if the IRA owner has not taken the full RMD for that year prior to his or her death, the beneficiaries must take any remainder of that RMD before the end of that calendar year. This can present real problems for families experiencing a death late in the year, since bereaved beneficiaries do not usually focus immediately on the decedent’s IRAs and RMDs. This is where the family’s tax and financial advisers need to be on the ball, to prevent an avoidable tax penalty.
To determine your RMD, you can use the worksheet provided as Appendix A of Publication 590-B. Here is an example of what the initial year’s RMD calculation for someone with an IRA would look like: Assume an IRA balance of $500,000 as of December 31, 2016, and you turned 70 on February 1, 2017. Divide that $500,000 balance by 27.4 to determine the 2017 RMD ($500,000/27.4 = $18,248.18). For subsequent years, the divisor changes according to the table: for 2018, it becomes 26.5.
If the IRA Owner Dies Before the Required Beginning Date
Believe it or not, after the IRA owner’s death, the rules get more complicated.
If the IRA owner died before the Required Beginning Date, and the sole beneficiary is something other than a person (e.g., a charity or the estate), also called an “entity” beneficiary, the entire account balance must be distributed by Dec. 31 of the fifth calendar year after the year of death. In that case, there are no annual distribution requirements, as long as the entire account is cleaned out by the end of the five-year period.
If the sole beneficiary is an individual, he or she may follow the above five-year rule, or elect to commence distributions in the calendar year following the year of death, based on the single life expectancy of that beneficiary (determined according to another IRS table (Appendix B, Table I). If there are multiple human beneficiaries, the life expectancy of the oldest beneficiary is used, unless the IRA has been split into separate accounts for each beneficiary. In that case, the life expectancy of each beneficiary is used for his or her separate account. The IRA custodian’s paperwork may limit the options to either of the above choices, but this seems to be rare in actual practice.
A spouse beneficiary has the above options, but also may delay distributions until the year the decedent would have reached age 70½, and then take distributions based on the surviving spouse’s remaining single life expectancy (per the IRS table). Most often, the surviving spouse utilizes an option (available only to a spouse) to convert (or “roll over”) the IRA balance to his or her own IRA, and then follows the basic rules noted above for an owner IRA.
If the IRA Owner Dies on Or After the Required Beginning Date
In this case, the rules get a little simpler. A sole individual beneficiary who is not a spouse must commence distributions in the calendar year following the year of death, based on the single life expectancy of that beneficiary or (if longer) the theoretical remaining single life expectancy (based on Table I) of the decedent. If the sole beneficiary is an entity beneficiary, the theoretical remaining single life expectancy of the decedent is used to determine RMDs to that entity beneficiary. The procedures for multiple human beneficiaries and a spouse beneficiary are basically the same as noted above (particularly the ability of a spouse beneficiary to make the decedent’s IRA his or her own IRA).
Of course, beneficiaries may always take out more than the RMD at any time; they would just have to be prepared to pay the associated taxes.
Having a trust named as a beneficiary can be complicated; it is treated as an entity beneficiary, unless it conforms to certain standards set forth in IRS rules, to allow a “look through” to the human beneficiary or beneficiaries of the trust for purposes of applying the RMD rules.
A combination of multiple beneficiaries. It gets more complex if there are one or more entity beneficiaries as well as human beneficiaries. Generally, in that case, the rules described above for a sole entity beneficiary are followed for all beneficiaries (entity or human), unless all the entity beneficiaries are “cashed out” by Sept. 30 of the calendar year following the year of death, in which case the rules applicable to only human beneficiaries are applied. Also, if separate accounts have been created for each human and entity beneficiary, each account can follow the rules applicable to that type of beneficiary (human or entity). Generally, charitable beneficiaries withdraw the whole portion allocated to them as soon as possible, since the distributions to them are not taxable.
Considerations for an inherited Roth IRA. There are no RMDs for a Roth IRA during the owner’s lifetime, but the beneficiaries must take withdrawals. Post-death, beneficiaries must follow the same rules described above, which are applicable to beneficiaries of traditional IRAs whose owner died before the Required Beginning Date, even though Roth distributions are generally non-taxable.
Combining IRAs. Finally, an owner of multiple traditional IRAs may aggregate those (and only those) account balances and take the aggregate RMD from one or more of those IRAs. A beneficiary of any inherited IRA may only aggregate the balances of inherited IRAs of the same type (Roth or traditional) from the same decedent (and not with any other IRAs owned or inherited by that beneficiary).
For qualified employer plans (such as a 401(k) or 403(b) plan), the RMD rules outlined above are mostly similar, except the above-mentioned aggregation opportunities are not applicable to 401(k) plans (but they are for 403(b) plans).
Strategies for Those Bequeathing or Inheriting IRAs
Some “best practices” in this area may include:
- Those who inherit their spouse’s IRA should consider converting it to their own IRA, unless there is a compelling reason to do otherwise. An example of an exception would be a spouse younger than 59½ who needs immediate access to the money. In such case, that person may wish to continue it as an “inherited IRA” so that a premature withdrawal penalty does not apply because it is a “distribution on account of death.” After reaching age 59½, that spouse may then convert the IRA to his or her own IRA.
- Where there are multiple human beneficiaries, split the IRA into separate accounts for each beneficiary after the IRA owner’s death as soon as practicable.
- Where there are both human and entity beneficiaries, either “cash out” any entity beneficiary by Sept. 30 following the year of death, or create separate accounts for each beneficiary as soon as practicable.
- Unless there is a good reason not to, make sure a beneficiary which is a trust qualifies as a “look through” trust.
- Unless there is a compelling reason otherwise, don’t name the estate as a beneficiary.
These rules are very complicated, but navigable with the help of a knowledgeable tax adviser.
As an attorney and Certified Financial Planner®, Rich leads the R. M. Davis Wealth Management Services Department and assists the portfolio managers with client questions on topics such as Medicare Part D, Social Security planning, 529 College Savings Plans, reverse mortgages and long term care insurance, to name a few. He also manages client portfolios himself.
Richard A. Carriuolo, CFP™ is Vice President and Director of Wealth Management Services at R. M. Davis, Inc., a registered investment advisor with offices in Portland, Maine, and Portsmouth, N.H. He is licensed to practice law in the states of Maine and Massachusetts. He is a graduate of Holy Cross College and Harvard Law School. He joined R. M. Davis, Inc. in 1994, after over 17 years of private legal practice with a Portland law firm. He has served on the Board of Governors of the Investment Adviser Association in Washington, D.C., and is currently a member of its Governmental Relations Committee. He has been a Certified Financial Planner ™ since 2001.
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