What Are Required Minimum Distributions? Why Do They Exist?
If you ask someone what he does for a living and he says he’s a dentist, there isn’t a follow up question.
People know what dentists do: They clean teeth, fill cavities, perform root canals and remind you to floss to no avail.
The same clarity does not exist for the financial planning professional.
Required minimum distributions are mandated by the Internal Revenue Service. Your RMD is the minimum amount you must withdraw from your account each year once you reach a certain age.
RMDs typically affect qualified accounts, such as 401(k)s and IRAs. The purpose of RMDs is to generate federal tax revenue sooner rather than later.
Many people, particularly those who don’t need or want the money for lifestyle expenses, feel “penalized” by RMDs.
However, it’s important to remember that they usually only affect money you received as tax-deductible contributions earlier in life.
That original tax-deduction reduced your taxes and IRS revenue, so RMDs are how the IRS forces taxable distributions to generate revenue on the back end. Otherwise, one may technically not spend their assets at all.
The calculation for RMDs is based on one’s life expectancy. As you get older, RMDs typically increase.
Are My Accounts Subject To RMDs?
Most likely! If you saved into a 401(k), 403(b), 457(b), TSP, SEP IRA, Simple IRA or traditional IRA and received a tax-deduction on contributions, the IRS is going to come knocking for their RMDs.
Roth IRAs, nonqualified accounts and permanent/cash value life Insurance contracts are not subject to RMDs.
Fun fact: the IRS imposes RMDs on Roth 401(k)s/Roth 403(b)s as well! It’s a common misconception that all Roth monies are not subject to RMDs. Only Roth IRAs get this benefit.
This can lead to missed RMDs, which trigger a 50% penalty on the amount not taken. For example, if you missed an RMD that was $6,000, the IRS will assess a $3,000 penalty.
Lastly, it’s important to note that each account type will have its own RMD.
However, if you have multiple IRAs, you may be able to satisfy your IRA RMDs by withdrawing the entire amount from one account.
When Are RMDs Due?
RMDs begin the year in which you turn 70 1/2 and are due by Dec. 31 annually.
However, there are some exceptions to the rule. Your first RMD can technically be paid in the year you reach 70 1/2 or by the April 1 after you turn 70 1/2.
This rule is rarely leveraged in practice due to the fact you’d need to take two RMDs within one calendar year, increasing your tax liability.
If you continue working past 70 1/2 and are an active member of a qualified plan (401(k), 403(b), etc.) you may technically delay your first RMD until the year you retire.
It’s important to note here that IRAs and business owners with 5% or more stake in the company do not receive this luxury.
RMDs are also due annually by Dec. 31 for inherited accounts that were previously subject to RMDs.
What Planning Technniques Can I Implement To Avoid RMDs?
Completely side-stepping RMDs is a tall order and likely not the wisest planning strategy to implement.
However, there are ways to strategically reduce and utilize one’s RMDs.
• Roth Conversions: You can convert your Traditional IRA into a Roth IRA.
The catch, of course, is that you must pay the taxes upon conversion.
Also, you can’t use monies within the IRA to pay the taxes that the conversion would generate.
You’ll need cash or nonqualified money on the sidelines to cover the tax bill.
While this strategy can be very effective, it can be challenging to implement for retirees.
I’d argue that it is most effectively employed in the years between retirement and the turning on of Social Security and/or pension income.
This allows you to strategically “fill-up” your tax bracket with systematic conversions spread out over time, say from age 62 to 67.
• Roth IRA/Non-Qualified Accounts: Funding Roth IRAs and nonqualified accounts rather than solely a qualified plan is a great way to reduce RMDs long term, assuming you aren’t maxing out your qualified account.
While foregoing the tax deduction may not be wise for those individuals in their highest earning years, Roth IRAs and nonqualified accounts can be of great long-term value to younger folks. Having multiple tax types saved in retirement can help create more flexibility when it comes to distribution planning.
• Qualified charitable distributions (QCD): This is one of the most common ways to avoid paying tax on RMDs, particularly if you’re charitably inclined.
Essentially, if you make donations to charity each year, you can choose to have all or part of your RMD sent to the qualified nonprofit of your choosing.
Neither you nor the charities you choose will pay tax on the RMD funds. Also, it is possible to do qualified charitable deductions to multiple charities within the same RMD year. The catch, however, is that QCDs technically need to be the first distributions you take from the RMD eligible account.
Working with your financial adviser can be critical to timing this appropriately. Lastly, the maximum QCD amount one can donate in a given year is $100,000.
• Journaling: Contrary to QCDs, journaling is the most obscure method of RMD planning. In fact, it doesn’t reduce RMDs or your tax burden at all. It simply allows you to maintain an investment position you like and not miss the market.
For example, let’s say you have a diversified stock portfolio within your IRA with a sizeable amount of Amazon stock. You need to take an RMD and know Amazon is the position you need to divest from, yet don’t want to sell the stock.
Technically, you are able to “journal” the RMD portion of Amazon stock from your IRA into a non-qualified account without missing any days in the stock market. The problem with this is that in order to be able to journal your position, you’ll need to have enough cash within the IRA to cover the taxes.
Of course, you could simply sell out of the position, satisfy the RMD, pay the tax and rebuy the position later.
Why some folks don’t opt to go this route is because it can take 10 business days for all of that to clear. In that timeframe, the stock price can go up – or down!
When it comes to your RMDs, it is best practice to plan and plan ahead. Your financial adviser should be able to help you navigate this process in a manner that is best suited for your personal needs, especially if your tax adviser and financial adviser are able to work together.
Don’t wait until the last minute to take your RMD, as the penalty may be hefty and the funds must clear from your qualified account by end of day on Dec. 31, which will be here before we know it.
The opinions expressed in this article are those of author and should not be construed as specific investment advice. All information is believed to be from reliable sources, however, no representation is made to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Any tax advice contained herein is of a general nature. Further, you should seek specific tax advice from your tax professional before pursuing any idea contemplated herein. Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design), and CFP® (with flame design) in the U.S., which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements. Fee-Based Planning offered through W3 Wealth Advisors, LLC – a State Registered Investment Advisor – Third Party Money Management offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor – Securities offered through Valmark Securities, Inc. Member FINRA, SIPC – 130 Springside Drive, Suite 300 Akron, Ohio 44333-2431 * 1-800-765-5201 – W3 Wealth Management, LLC and W3 Wealth Advisors, LLC are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc.
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