November 2019: Required Minimum Distribution (RMD)
This month’s newsletter we will be discussing IRA Required Minimum Distributions, RMD for short. RMDs are just as their name states: The IRS requires IRA (Individual Retirement Account) owners to take distributions from their accounts starting at the age 70 ½. This newsletter will discuss the RMD law, it’s purpose, and what your potential options are as an IRA account owner.
To understand the purpose and function of RMDs, it helps to have a basic understanding of IRAs, specifically Traditional IRAs, not Roth-IRAs. The RMD law does not apply to Roth-IRAs. Traditional IRAs, are IRAs which contain funds that have never been taxed before, which thereby allow an account owner to deduct their contributions from their income. The funds within the Traditional IRA then have the potential to be invested and grow tax-deferred. When the IRA owner withdraws funds from their IRA, the entire distribution is taxed at the account owner’s ordinary income tax rate. IRA account owners cannot withdraw funds from an IRA (without penalty) until they are at least 59 ½ years old, unless the funds are withdrawn under special circumstances. Given that this IRA money has never been taxed and it has been sitting in the IRA for such a long period of time, the government will finally be able to tax these funds due to the RMD. The RMD forces IRA owners to take distributions from their accounts in order for the IRS to tax those funds.
Now, let’s explain the details. RMDs are required of account holders on an annual basis starting the year in which the account owner turns 70 ½ and will continue even after the death of the account owner. Once started, the RMD must be withdrawn by the end of the year, except for the first year. This first RMD payment can be delayed until April 1st of the year following the one in which the account owner turns 70 ½. If someone turned 70 today, 10/23/19, they would not be 70 ½ until 4/23/20, therefore their withdrawal deadline would be 4/1/21. If you do wait till the year after you turn 70½ then you will be required to have two withdrawals that year, one for your 70 ½ year and one for your 71 year. If an account owner does not withdraw their RMD during any year, they will be penalized by the IRS in an amount that is equal to 50% of their RMD for that respective year.
The amount of the RMD is based upon a life expectancy factor set by the IRS. To determine your RMD, you would take the year-end market value of your IRA for the previous year and divide it by the life expectancy factor. You can view the RMD life-expectancy chart, here. As an example, if an IRA account owner was 75 with a previous year-end account value of $100,000, a life expectancy factor of 22.9, their RMD for this year would be $4,366.81 ($100,000/22.9). Because of these variables, your specific RMD amount changes every year. If the IRA account owner voluntarily withdraws funds from their IRA after the age of 70 ½ and it is equal to or exceeds their RMD for that year, then the RMD requirement is considered fulfilled. In the event that you inherit an IRA from a non-spouse that had previously been withdrawing RMDs, you will be expected to follow a specific set of rules for that Inherited IRA. If you ever inherit a non-spouse IRA, we recommend contacting a professional within a year of the account owner’s death for guidance. More can be read about Inherited IRAs, here.
One final note about the IRS and their treatment of IRA accounts. Regardless of how many Traditional IRA accounts you may have, the IRS considers all of your IRA accounts to determine the total market value. Some investors have IRAs scattered throughout different investment firms and former employers. For those investors with accounts in multiple places, your RMD amount is based upon the aggregate total market value of all your Traditional IRA accounts. However, though your RMD will be based upon the total value of all these accounts, you can withdraw your RMD from any one of your accounts, so long as the amount withdrawn covers your total RMD requirement.
The main component to planning for RMDs, is the tax component. This is because when an RMD is withdrawn, it will be taxed as ordinary income. Therefore, when planning for RMDs, your current and future income should be considered. Keep tax planning in mind when reading our RMD strategies below.
Required Minimum Distribution Options
Take the Distribution: The most simple and easiest option for your RMD would be to withdraw the required amount and pay the taxes on those funds. This money can then be spent or be put back to work in a taxable investment account.
Qualified Charitable Distribution (QCD): If you are 70 ½, make donations to qualified charities and may not need the income, or would like to prevent yourself from entering a new tax bracket, consider a QCD. Currently, the IRS allows IRA account owners to use their RMD funds to be contributed to a qualified charity. The IRA account owner does not have to contribute their entire RMD amount, it can be just a portion. The contribution must be paid directly to the charity from the IRA and be completed before year-end. There are a multitude of tax advantages when an IRA owner chooses to make a QCD from their IRA, therefore we would recommend you consult a tax professional if you are interested in QCDs.
Convert IRA to a Roth-IRA: IRA account owners that are currently in a lower tax bracket and do not expect additional income for the year, might consider converting some of your Traditional IRA funds to a Roth-IRA (which is a tax-free account).To do this, account owners would convert their funds from a Traditional IRA to a Roth-IRA which would then require the account owner to pay taxes on the converted funds, because this is considered a distribution. But, by converting the funds, this provides the account owner the ability to grow their funds tax-free for the rest of their life. This strategy impacts RMDs because by converting the funds, you are reducing the value of the Traditional IRA, which then reduces the RMD amount because the RMD is based upon the value of the Traditional IRA. This provides Traditional IRA account owners the ability to plan for future RMDs, more control over their distribution amounts, and thereby the ability to manage the taxes on their income. Warning, it would be best to convert IRA funds before you turn 70 ½. This is because these conversions do not fulfill the RMD requirements and therefore do not count as an RMD.
Though Required Minimum Distributions are designed to provide tax revenues and to reduce IRA account values over time, if you plan for these distributions ahead of time, then you can effectively manage the tax effects that are created from these distributions. As stated above, if done right, RMDs can be avoided all together. If you have any questions concerning RMDs, please contact us.