It is estimated that each year about 4 million Americans born during the 1946-1965 “baby boom” period in the United States will turn age 70 ½ for the next twenty years. For people who hold assets either in traditional IRA accounts or qualified defined contribution retirement accounts reaching age 70 ½ typically means that annual minimum distributions must be made from these retirement savings accounts or stiff penalty taxes will be imposed. In terms of policy, one of the major justifications for requiring these distributions is to steer the use of tax-favored retirement accounts towards providing for the account owner’s retirement rather than being a tax-shelter for the family’s “nest egg.” Planning for how to handle these distributions should be a significant component of just about anyone’s overall financial planning. This post touches on the mechanics of when required minimum distributions (RMDs) from traditional IRAs and qualified retirement plan accounts (e.g. 401(k)’s, 403(b)’s, etc.) must begin and how the amount that must be distributed each year is generally determined.
When RMD’s Must Begin. For traditional IRAs, RMDs must be made by April 1st of the year after the account holder turns 70 ½. For some qualified plans, distributions may begin on the later of April 1st of the year after the account hold
er turns 70 ½ or the date of retirement (this rule does not apply if the person owns 5% or more of the plan’s sponsor). Thus, if an individual is a participant in such a plan and does not plan to completely retire from the plan sponsor after 70 ½ (perhaps by working just a few hours a week), it may make sense to rollover his or her IRA’s into the plan in order to continue to avoid RMDs after age 70 ½.
When considering when to begin RMDs, it is important to note that although an RMD must be made by April 1st of the year after an individual turns 70 ½, the first “distribution year” is actually the year the individual turns 70 ½. So if an individual turned 70 ½ in 2016 they could wait until April 1, 2017 to take their 2016 RMD. However, they would also have to take their 2017 RMD in 2017. This potentially would cause “income bunching” in 2017.
Determination of the amount of the RMD. There are a number of ways to satisfy the RMD requirement through the purchase of a variety of qualifying annuity products with retirement account funds. More commonly, though, a table derived from life expectancy data is used that specifies the percentage that must come out of the account each year after age 70 ½. The base amount that the percentage is multiplied by is the fair market value of the retirement account(s) at December 31st of the year preceding the distribution year. In other words, the base amount for a 2016 RMD would be the fair market value of the retirement account(s) at December 31, 2015. Except in the case of a traditional IRA where a spouse who is more than ten years younger is the sole beneficiary of the account, an abbreviated version of the table that is used is as follows:
The age that is used from the table is the age of the person on their birthday during the distribution year. For example, if someone turned 72 during 2016, 3.91% would be multiplied by the fair market value of their retirement account holdings on December 31, 2015 to determine the 2016 RMD amount.
Although the RMD amount is computed from the total fair market value of all of the taxpayer’s traditional retirement accounts, the amount need not come out of the accounts proportionally but can be distributed however the individual directs. For example, assume an individual has two IRA’s: IRA-1 and IRA-2. The RMD for IRA-1 is $30,000 and the RMD for IRA-2 is $50,000. The individual’s total RMD for the year is $80,000, but it can all be distributed from either IRA-1, IRA-2, or whatever combination the taxpayer chooses. Many financial institutions automatically distribute the RMD amount by transferring funds to a separate non-IRA account absent specific instruction not to do so by the taxpayer so taxpayers planning on taking RMD’s from a single account should contact the financial institutions holding their other IRA’s to make sure unwanted distributions are prevented.
Written by: Brian Spencer