As we approach the end of the year, many investors might be needing to take a required minimum distribution (RMD) from a retirement account, either one that they own or one that was inherited. This article will discuss RMDs, how they are calculated, who needs to take one, and the tax implications of these distributions.
Each year, most investors over the age of 72 are required to take an IRS-specified amount of money out of pre-tax retirement accounts (IRAs or company-sponsored retirement plans). This starting age was 70.5 for a long time but was recently increased with the passage of the SECURE Act of 2019. Typically, the retirement accounts containing pre-tax contributions have grown over the entire career of a worker and the government eventually wants to receive their tax share of the account value. This distribution does not have to be spent; it can simply be moved from a retirement account into a taxable account like a traditional brokerage. However, the distribution amount is reported to the IRS as taxable income in the year of the withdrawal, regardless of the final destination for the money (e.g. spent or saved). You can always distribute more than the RMD from an IRA if additional funds are needed but the RMD is the lowest amount to withdraw each year. The penalty for missing an RMD is stiff—50% of the amount that should have been withdrawn but was not, plus interest.
The annual calculation of an RMD is fairly straightforward: the IRS publishes a life expectancy table which provides a factor to divide the prior year’s ending account balance by in order to determine the current year’s RMD. For example, someone with a $1,000,000 IRA balance on 12/31/2021 that turns 72 in 2022 will have a factor of 27.4, which represents a roughly 3.65% withdrawal (100 / 27.4). Dividing the $1,000,000 balance by the 27.4 factor gives a 2022 RMD of $36,496. This denominator factor decreases every year that you age, so the percentage of the account that needs to be distributed annually will increase. A 90-year-old needs to take out 8.2% of the account versus the 3.65% distribution for a 72-year-old. Someone living to age 100 would be required to withdraw over 15% of the account each year. Due to the changes in life expectancy of Americans, this table of factors was revised in 2022 for the first time since 2012.
It is important to note that retirement funds saved into a Roth IRA do not have any RMDs over the lifetime of the original owner. Since these accounts contain after-tax funds, the government has less incentive to force distributions of these accounts since doing so does not generate any tax revenue.
There are some circumstances in which the annual RMD may be waived or delayed. In the calendar year of turning 72, you can delay the first RMD until April 15th of the following year, but that does not waive that year’s distribution so you would effectively have a double RMD in the year of turning 73. If distributions are relatively large, this might not be an effective strategy as the increased tax effect from two RMDs on one income tax return can be significant.
It is also permissible for workers over age 72 that have not yet retired to delay taking RMDs from their current company’s retirement plan, provided the worker does not own at least 5% of the company. In this case, the RMDs from the employer-sponsored plan would begin in the first year of retirement based on the worker’s age attained in that year.
There are also different life expectancy tables for certain situations, such as a spouse that is at least ten years younger and is the sole account beneficiary, that are beyond the scope of this article. The financial planners at Moller Financial Services are happy to discuss any more nuanced questions regarding situational RMDs.
This review has thus far centered on RMDs for retirement accounts with an original owner. When a loved one passes away, they will typically have a spouse or child named as the beneficiary to inherit their retirement accounts. There are different distribution rules for accounts that were inherited versus being owned by the original account holder.
For spouse beneficiaries, the easiest option is usually to combine the retirement accounts into their own retirement account and take one annual distribution based on the life expectancy factor of the surviving spouse. A spouse can also open an inherited IRA and start distributing the account immediately over their expected lifetime if they need to access the money penalty-free before age 59.5.
The enactment of the SECURE Act changed the rules for non-spouse beneficiaries significantly. Whereas inheritors before January 1, 2020 could space out the RMDs from an inherited IRA over their own life expectancy (a 50-year-old was only required to distribute 2.76% of the account), starting in 2020 any newly inherited retirement accounts by a non-qualified beneficiary are required to be emptied within ten years. Qualified beneficiaries—surviving spouses, minor children, disabled people, and heirs less than ten years younger than the account owner—are exempt from this ten-year rule and may still choose to use their own life expectancy to calculate RMDs. This ten-year rule applies to both pre-tax and Roth retirement accounts. In doing so, the government’s tax revenue is accelerated as a previously-small annual inherited IRA RMD now totals 100% of the account in the ten years after the original owner’s death. The IRS is still determining if inherited IRA owners will need to take an RMD each year or just make sure the account is empty after year ten. Heirs subject to the ten-year rule or an annual RMD are also able to access the funds without penalty before age 59.5, unlike a spouse who combines an inherited account into their own.
Managing the potential tax burden from retirement account distributions can be a critical component of long-term tax planning. There are strategies, such as early-in-retirement Roth conversions, that can reduce the value of pre-tax accounts and thus lower the annual forced taxable distribution once the account owner reaches 72. Once the RMDs are started, there is no way to turn them off, so forward thinking is required in order to minimize the lifetime tax consequence of distributing funds from these types of accounts.
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