You’re supposed to be easing into retirement and looking forward to a slower phase of life. Sometimes, though, it can seem as if everything is getting more complicated, especially when it comes to financial matters!
Mandatory IRA withdrawals, commonly referred to as RMDs (for “required minimum distributions,”) are a frequent source of confusion for retirees. There are plenty of helpful publications available, but because these publications generally try to cover the specifics of every possible situation, they go into a level of detail that confuses the average investor.
To keep things simple as possible, let’s just focus on the thought process behind RMDs, review how they affect the majority of retirees, address some of the common mistakes people make with them, and make sure you know where to go to find more information.
“Why do we have RMDs in the first place?”
We all know about the two inevitable things in life – death and taxes. Since the majority of accounts used to save money for retirement offer some type of tax advantage during the accumulation phase (pre-retirement,) the government expects you to pay taxes on the money you take from them in the distribution phase (retirement). Even more simply, if Uncle Sam encourages you to put away more money by giving you a pre-retirement tax break for doing so, it’s a pretty sure bet that you’ll have to give him his due when you start actually using that money.
Money inside a traditional IRA typically accumulates on a tax-deferred basis. That means you pay no taxes on any increase in the account’s value during the years that it is (hopefully) growing. With qualified retirement plans such as 401(k)s and 403(b)s, you are also able to contribute on a pre-tax basis within certain limits, so your retirement savings reduce your taxable income. And if you qualify for a deductible IRA, that can also reduce your taxable income. All these pre-retirement tax benefits should make it easier to understand why the government comes back for its share later on!
Roth IRAs are handled a bit differently. Because contributions to a Roth IRA are done with after-tax dollars and do not reduce your taxable income, Uncle Sam does not come back at retirement time with his hand out. There are, of course, a number of special circumstances where withdrawals from a Roth IRA would be subject to taxes in some way, but the point of this article was to focus on the simplest of retirement scenarios rather than veer off into less common complexities. If your account had any sort of tax advantage while you were putting money into it, is most likely subject to RMDs, but you should rely on the advice of a professional familiar with your personal situation rather than making any financial decisions on the basis of an article such as this.
“When do I have to start taking RMDs and what are they based on?”
According to the letter of the law, you are required to start RMDs by April 1 of the year following the year in which you reach age 70½. That’s a little difficult to translate into real life terms, and there are exceptions to this per USA Today; so read on for a couple of examples on how it actually works. First, though, please note that more people are continuing to work into their retirement years these days. If you continue to work past age 70½ and are still participating in your employer’s retirement plan, you may be able to delay taking RMDs. Consult a tax professional, financial planner or both to determine if this applies to you.
Every pre-retiree should take note of where his or her birthday falls relative to April 1st of each year, and also note the timing of the six-month mark that follows it. Let’s look at two individuals whose RMDs are affected by the calendar in different ways to see why this is so.
We’ll start with Fred, who was born on Valentine’s Day, Feb.14th. If Fred turned 70 on Feb. 14th, 2012, he will be 70½ on July 14th, 2012. Fred can actually delay starting his RMDs until after he turns 71, as long as he starts them before April 1st, 2013. That’s because he turned 70½ in 2012 and 2013 is the year following that year. Fred can take his first distribution in 2012 if he wishes. Or he can choose to wait until early 2013, as long as he takes the money out of his account on or by April 1st, 2013. Most people in Fred’s shoes will wait until after the end of 2012, though. That’s because the amount of the first RMD is based on the value of your retirement accounts as of the end of the calendar year in which you turn 70. (If Fred does take his first distribution during 2012, he should consult a professional for assistance in determining the amount.)
What a lot of people in Fred’s situation forget is that technically, a distribution taken in the early part of 2013 represents a distribution for the 2012 calendar year. That means Fred has to take a second distribution during 2013, which would fulfill his RMD for the 2013 calendar year.
Mary, on the other hand, was born on Christmas Day, December 25th. If she turns 70 this year, 2012, she will turn 70½ on June 25th, 2013. When is the latest possible date for her to take her first RMD without penalty? April 1st, 2014 – the year after the year in which she turned 70½, 2013. What is that RMD going to be based on? The value of her retirement accounts as of 2012 – the year when she turned 70. If Mary takes her first RMD in 2013, she does not have to take another distribution until 2014, and she has until December 31, 2013 to take it.
“How much is my RMD and where do I have to take it from?”
Retirees are generally relieved to find out that it is not necessary for them to do any elaborate calculations to determine how much they need to withdraw. The custodial institutions will calculate the required amount for each retirement account and inform you in writing. To get a better idea idea about the results of these calculations the Financial Industry Regulatory Authority or FINRA offers an online RMD calculator. As noted earlier, the amount is based on the account value as of December 31 of the preceding year, divided by a “distribution period” figure taken from the Uniform Lifetime Tables provided by the IRS. (In certain situations where one spouse is significantly younger or the spouse is not the sole beneficiary, alternative methods are used.) Every institution has its own schedule and method for notification; some may simply place the information on your account statement while others send a separate notice. Before you begin taking RMDs, check with each institution where you have a retirement account to find out how and when they will provide you with this information.
Keep in mind that if you have multiple retirement accounts, such as a 401(k) and two traditional IRAs, you are required to combine the account values as of December 31 as a basis for RMD calculations. Your 401(k) custodian is not aware of the IRAs so the figure it provides you will not reflect their value. You will need to combine this RMD figure with the information provided by your IRA custodians to determine the actual withdrawal amount you need to take. Many people think that they have to take a withdrawal from every account they have. This is sometimes, but not always, the case, as it depends on the type of retirement account you are dealing with. If you have multiple IRAs, you do have the option of taking the year’s total withdrawal amount from one account and leaving the others to tap in future years.
“Where can I learn more?”
While much effort has been made to present this information simply, it may still be more than the average person can absorb at one sitting. So it’s always best to use an article of this type to familiarize yourself with the basics and to then work with a financial professional who can help you determine how to apply them to your particular situation. There are substantial penalties for not taking the full amount of your RMD or making mistakes in other areas that involve retirement accounts and withdrawals; why run the risk of incurring them?