If you’re nearing age 70½, it’s time to start planning for required minimum distributions (RMDs) from your traditional IRA or employer-sponsored retirement plan. Pay attention because, even if you don’t need the funds, taking RMDs will increase your taxable income and decrease the amount of savings that continue to grow tax-free. Here are some tips and strategies for minimizing the impact of RMDs.
What are the rules?
Traditional IRAs and most non–Roth-qualified retirement plans are subject to RMD rules. Generally, you must take your first RMD in the year you reach age 70½, although you may delay the first distribution until April 1 of the following year. After that, RMDs are due by December 31 of each calendar year.
There’s one exception for employer-sponsored retirement plans: If you continue to work for that employer past age 70½, you may delay RMDs until April 1 of the year following your retirement, provided:
- You continue to participate in the plan,
- The plan documents permit this option, and
- You don’t own more than 5% of the company.
To calculate your RMD for a particular year, take your account balance as of December 31 of the preceding year and divide it by your remaining life expectancy (according to IRS tables) or, if your spouse is more than 10 years younger than you, by the longer joint and survivor life expectancy.
What if you miss the deadline?
The penalty for noncompliance is harsh: 50% of the amount by which the RMD exceeds any distributions you took during the year. For example, say you’re required to take a $30,000 RMD from your traditional IRA by December 31, 2017. You withdraw $10,000 in June 2017, but make no further withdrawals the rest of the year. Your penalty is 50% of $20,000, or $10,000. However, you can generally avoid the penalty fairly easily by taking the amount that had been missed and request a penalty waiver from the IRS.
Should you delay your first RMD?
When you reach age 70½, you can delay your first RMD until April 1 of the following year. But should you? Let’s say you turn 70½ in March 2017. Your first RMD won’t be due until April 1, 2018 (based on your December 31, 2016, account balance).
Your second RMD, however, will be due by December 31, 2018, so you’ll have two distributions in 2018. This will increase your taxable income in 2018 and, depending on your circumstances, could push you into a higher tax bracket or reduce the benefits of certain exemptions or deductions. If that’s the case, you may be better off taking your first RMD in 2017. On the other hand, if you expect your income to decline substantially in 2018, delaying the RMD may make sense.
To determine the right strategy, weigh the tax-deferral benefits of delaying your first RMD against the potential tax costs of a double distribution.
Should you convert?
One strategy for avoiding RMDs is to convert a traditional IRA or employer-sponsored plan to a Roth IRA or plan. Roth accounts that you create aren’t subject to the RMD rules (inherited accounts, however, are subject to RMD), so you can allow them to continue growing and compounding tax-free throughout your lifetime.
In addition, withdrawals are generally tax-free. The converted amount is taxable in the year of conversion. So you’ll need to carefully weigh the potential future benefits of conversion against the initial tax cost. Also, keep in mind that to the extent you have basis in your traditional IRA — say, for instance, because of nondeductible contributions previously made — you’ll be able to reduce the amount of the conversion that is taxable.
Are you charitably inclined?
If you plan to make substantial charitable gifts, consider using a qualified charitable distribution (QCD). This tax break, made permanent in 2015, allows taxpayers age 70½ or older to transfer up to $100,000 per year tax-free directly from an IRA to a qualified public charity. In addition, you can apply the transferred amount toward your RMD for the year.
A QCD may provide a tax advantage if donating other assets wouldn’t be fully deductible — for example, because you don’t itemize or the gift would exceed adjusted gross income limits. It may also be desirable if including an RMD in income would trigger unwanted tax consequences, such as reducing deductions or increasing taxes on Social Security benefits.
QCDs aren’t available for employer-sponsored plans, but you may be able to do a rollover into an IRA and then make the QCD from there. Keep in mind that, to benefit from a QCD, you must make the transfer after you reach age 70½. It’s not sufficient to make the transfer during the year in which you turn 70½.
Have a plan
If you’re nearing retirement age, it’s critical to begin planning for RMDs. Work with your tax advisor to develop a plan for dealing with, and minimizing, RMDs.
What about inherited benefits?
The required minimum distribution (RMD) rules are a little different if you inherit an IRA or qualified plan account from someone else:
- If you inherit benefits from your spouse, you may roll them into your own IRA and delay RMDs until you reach age 70½.
- If you inherit an IRA (including a Roth IRA) from someone other than your spouse, and roll the funds into an “inherited IRA,” you must begin taking RMDs by December 31 of the year following the year of the account owner’s death, but you may stretch RMDs over your life expectancy.
- If you inherit a qualified plan account from a nonspouse, and the plan permits rollovers into inherited IRAs, you can stretch RMDs over your life expectancy. Otherwise, you must withdraw the funds within five years.