Making individual retirement arrangements can be complex. Retirement plans like 401(k)s and IRA accounts allow individuals to save for their future in a tax advantaged manner. IRA and 401(k) contributions are often tax deductible and gains are tax deferred – you only pay taxes when you withdraw money from your account.
So let’s say you contribute money to a 401(k) plan in your 20s. You won’t pay taxes on it until you start withdrawing money – likely when you’re in your 60s. This gives you ample time to grow your savings and investments for retirement.
However, the government will eventually come to collect its taxes. IRAs and 401(k)s are designed to help fund retirement, they’re not tax-free accounts intending to pass wealth onto future generations. As part of that, Congress established rules that require annual distributions from tax-advantaged plans once you reach age 70.5.
Required minimum distribution (RMD) rules can be complex. In fact, even the age of 70.5 isn’t a hard and fast start in all situations as many factors determine when the RMD rules actually affect you. Let’s break down RMD requirements into the basics you need to know.
When Do RMDs Start?
RMD rules can be divided in two distinct categories: during an individual’s life and after an individual’s death. While an individual is alive, RMD rules generally kick in after age 70.5. If you keep working after age 70.5, in some cases you can defer certain account RMDs until retirement.
If you continue working for an employer past age 70.5 and aren’t a “5% owner” of the company, you can delay your required beginning date for RMDs of that employer’s plan until you retire. For example, if your employer has a 401(k), you can push off RMDs until April 1 in the year after you retire. However, if you had an IRA on the side, it would be subject to RMD rules at age 70.5 – and continued employment wouldn’t have an impact on your retirement savings plan.
Planning Tip: If the 401(k) plan offered the ability to accept rollovers, you could rollover the IRA to the 401(k). RMD rules apply to the account the money is currently in – not where it used to be. So, rolling an IRA to a 401(k) to continue working past the age of 70.5 would exempt your money from RMD rules until you retire.
After an individual dies, RMD rules for the new owner generally kick in the following year. These required distribution rules that apply to inherited IRA and 401(k) accounts are more complicated than the RMD rules applied during the account owner’s life.
For starters, you have to factor in if the owner died prior to beginning their RMDs and who the beneficiary of the account is. Beneficiaries also have a few options when it comes to withdrawing from the inherited retirement account. A spouse or non-spouse beneficiary can stretch IRA distributions over their own life expectancy; a spouse or non-spouse beneficiary can withdraw more money than required at any time; in some cases all assets must be withdrawn by the fifth year after the original account holder’s death; a spouse beneficiary can take distributions based upon the account owner’s remaining life expectancy; and a spouse that inherits an account can even push off RMDs until they reach age 70.5.
If spouses don’t want to keep the IRA in the name of the deceased original account owner, they can roll it over into their own IRA or retitle the inherited account. This gives spouses the most flexibility with regards to inherited accounts. For those with the least amount of flexibility, you would look at non-person beneficiaries. For non-person beneficiaries (e.g., trusts, estates, companies, non-profits) distributions must happen over five years.
When an individual reaches age 70.5, they have to start taking their RMDs by April 1 of the following year. If you turned 70 on March 15, 2019, you would reach age 70.5 on Sept. 15, 2019. You’d have until April 1, 2020, to take your first RMD. However, this wouldn’t count as your RMD in 2020, which would still need to occur by the end of the year.
The general rule regarding RMDs is they have to be taken by Dec. 31 of each year. Taking two RMDs in a year could increase your tax burden as you now have two taxable distributions happening. While you have until April of the following year to take your first RMD, it might make more sense to take it in the same year you turn 70.5.
RMDs are calculated in a simple manner. Divide the account balance from the previous year by a life expectancy factor provided by the IRS.
Let’s say your 401(k) had a balance of $200,000 on Dec. 31, 2018. If you turned 73 in 2019, find age 73 on the table and the corresponding applicable distribution period devisor of 23.8. Divide $200,000 by 23.8. The answer – $8,403.36 – is the RMD amount you’d have to take from your 401(k) by Dec. 31, 2019.
If you don’t take the RMD by the end of the year, you could owe a 50% penalty tax on it in addition to the ordinary income taxes you’d already owe. However, you can take out more money each year – there’s no maximum cap on yearly withdrawals.
If you have multiple 401(k) plans, you would need to perform the same RMD calculation with each plan and take the distribution required from each individual plan. You can’t combine your RMDs from one 401(k), though. So, if you had four plans, you would need to take four separate RMDs – one from each.
IRAs are different. You can aggregate the account balances and take one distribution to meet the RMDs from multiple IRAs. If you have inherited accounts, you generally cannot aggregate them together unless it is IRAs from the same deceased owner.
What Accounts Are Subject to RMDs?
Determine what accounts RMD rules apply to. For the most part, your retirement accounts – ERISA covered qualified retirement plans and IRAs – are subject to the rules. Qualified retirement plans include 401(k)s, defined benefit plans, target-benefit plans, ESOPs, stock bonus plans, cash balance plans, profit-sharing plans and money purchase pension plans. The rules also apply to traditional, SEP, and SIMPLE IRAs. Government plans and the Federal Thrift Savings Plan are also subject to RMDs after age 70.5.
Roth IRAs present a unique counter option. When an individual is alive, they’re not required to take an RMD from their account. Roth IRAs are only subject to the RMD rules once an individual has passed away. However, Roth accounts in 401(k)s, 403(b)s and the federal Thrift Savings Plan are subject to RMDs after age 70.5.
Planning Tip: Roll the Roth accounts like Roth 401(k)s over to a Roth IRA before age 70.5 to avoid RMDs in the future. But remember, even Roth IRAs can be subject to RMD rules once inherited.
Your retirement account might be yours to save and spend, but rules dictate when you might have to tap into it. Understand how RMDs will impact your retirement and future security. And stay current on legislation that might affect RMDs.
Congress is considering legislation in the SECURE Act that would change aspects of RMD rules. The SECURE Act would eliminate many instances where inherited account RMDs could be stretched out over the life of the beneficiaries. The new law would require full distributions to occur within 10 years for many beneficiaries. This would impact retirement and estate planning significantly.
If you’re planning for your own RMDs or looking out for the estate planning ramifications of leaving a retirement account to your heirs, keep up to date with these rules as they’re likely to change in the near future.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Before rolling over your retirement account, consider all available options, which include remaining with your current retirement plan, rolling over into a new employer’s plan or IRA, or cashing out the account value. When deciding between an employer-sponsored plan and IRA, there may be important differences to consider – such as range of investment options, fees and expenses, availability of services, and distribution rules (including differences in applicable taxes and penalties). Depending on your plan’s investment options, in some cases, the investment management fees associated with your plan’s investment options may be lower than similar investment options offered outside the plan.