The short answer: a Required Minimum Distribution. Do you have an IRA or 401K? You cannot defer your taxes indefinitely. The general rule states that, once you attain age 70.5, you must start taking taxable withdrawals from your account. To make the discussion easy, I will speak on IRA accounts. For the most part, the same rules apply to 401K accounts if you are no longer working for the employer. And I am excluding Roth IRAs from this discussion.
The IRA contains a contract with the US government: “I can put money away pre-tax, but during retirement I must start paying taxes on the accumulations.” You don’t remember making that contract, you were just thirsty for a tax deduction. Let’s break down the RMD:
- Required – starting the year you attain age 70.5, and every year after
- Minimum – you can take more, but not less
- Distribution – it must come out of the IRA
What happens if you forget? The penalty is 50% of what you should have taken. Ouch! I was supposed to take out $10,000 so my penalty is $5,000; plus, I have to distribute the $10,000 albeit late and pay income taxes on that. In extreme cases (high tax bracket taxpayers), my penalties and taxes (federal and state) could exceed the amount of the distribution. Double ouch!!
Exception to penalty: If you forget the year you turn age 70.5, this is the one exception. Then you must take the distribution the following year before April 1st and you must take out another RMD for the current year before December 31. You will be doubling up your taxable distribution in the year your turn 71.5. (You may wonder, as I often do, why the IRS deals in half-years? Couldn’t decide 70 or 71, so they chose 70½? Personally, I quit counting half-birthdays when I was 6½ years old.)
Required. Any other escape hatches? Gifting directly to charity avoids taxation. If you are “RMD age”, you can redirect your IRA distribution to a charity. The funds must go directly to the charity from the IRA and not hit your checking account. The IRA distribution is nontaxable to you, but you don’t get a charitable contribution. In almost all cases, this technique is preferable to declaring taxable income and offsetting with a charitable deduction.
Minimum—but don’t interpret as maximum. Many people will never take more than the minimum, but you are certainly allowed to take more. While we focus on the minimum in order to keep our taxes lower, let’s look at some planning opportunities for taking more:
- If your taxable income will be unusually small this year, a larger IRA distribution means smaller RMDs in the future. Pay smaller taxes now instead of larger taxes later. Let’s say you seldom get to deduct medical expenses, but in one year you incur massive medical deductions. You could take IRA distributions this year at very low tax rates because of your reduced taxable income/lower tax bracket. Example: spouse goes into a memory care unit, you don’t have long-term care insurance, and your medical costs are $80,000 this year. Increased IRA distributions might result in little or no taxes.
- What if your children (heirs) are in high tax brackets, much higher than yours. You might want to take more than your RMD, pay the taxes, and have your children inherit after-tax dollars. A $10,000 IRA distribution might cost you $1,200 (12%) but cost them $3,700 (37%); they would pay 3X what you would.
How do you calculate your RMD? We might discuss that in a future article. You can research this on your own by downloading IRS Publication 590 which has all sorts of information on IRA accounts.
Another topic beyond our scope is Inherited IRA accounts (aka, Beneficiary IRAs). They also have RMDs, but the rules are much more restrictive. Publication 590 will shed light on those. And beyond your self-education on IRAs, consult with a qualified tax professional before taking action.
I will leave you with two thoughts: First, don’t miss your RMD in any year. Second, because it says “required”, you can still do planning around the taxability of the distributions.