Monday, 4 May 2015

After putting away much of your retirement savings in tax-deferred accounts, there comes a time when you can't defer any longer: Uncle Sam wants his cut.

That means that each year, you need to take a Required Minimum Distribution (RMD) out of your retirement savings plan. If you're retired, these RMDs will become important the year you turn 70 ½ years old.

Here's how they work:

The government has tables that estimate how much of our savings we'll need to use each year when we're retired. We're required by law to withdraw money from those tax-deferred retirement accounts each year.

The basic idea of RMDs

Let's use a simple example of a man who, according to the table, needs to withdraw 5 percent of his total savings each year for 20 years. He has $200,000 in one of these tax-deferred retirement accounts. So each year, his RMD will be $10,000.

That money is considered ordinary income for the year he pulls the money out of his retirement account and is taxed at the man's income tax rate in the year he withdrew the money, even though he didn't work that year to earn it. So if the man were in a 15 percent tax bracket, he'd pay $1,500 in taxes on the withdrawn amount each year. This example is highly simplified, of course, and doesn't take into account other earnings, deductions, etc.

What accounts require RMDs?

You have to take an RMD on any accounts that you set up for retirement and didn't pay taxes on when you put money in them. That includes:

  • Traditional IRAs
  • SEP IRAs
  • IRAs that were rollovers
  • IRAs that were inherited
  • 401(K)s
  • 403(B)s

RMDs are NOT required on a Roth IRA. If you set up a Roth IRA, you paid taxes on the money you put in a Roth IRA when you earned it.

When to start making RMDs

You'll need to start making RMDs after you turn 70 ½ years old unless:

  • You're still working
  • You're still participating in your company's retirement plan and
  • You don't own more than 5 percent of the company

If you meet all three of those requirements, you don't need to take RMDs until the 1st of April following the year you retire. If you don't meet those requirements, you need to take RMDs starting April 1st after the year you turn 70 ½. After that, you need to take RMDs by December 31st of each year.

Be careful. You could accidentally force yourself to take two RMDs in a year. Say you turn 70 ½ on June 1, 2014, but you don't take the RMD until April 1, 2015. That RMD applies for the 2014 tax year, but you'll need to take another one for the 2015 tax year no later than December 31, 2015. By taking both the 2014 and 2015 distributions in the same tax year, you might boost your 2015 income to a level at which you're in a higher tax bracket. In this example, if you took the 2014 RMD in 2014 and the 2015 RMD in 2015, you might avoid paying higher taxes.

If you don't take an RMD

You'll pay a penalty of 50 percent of the portion not withdrawn. So if the guy in our previous example who is required to take $10,000 a year only takes $4,000, he'll pay a penalty of 50 percent of the remaining $6,000 AND he'll still have to take the $6,000 out and be taxed upon it as income.

A smart way of taking RMDs?

If you have an assortment of retirement plans that are subject to RMDs—say, a variety of IRA accounts — you don't need to take equal portions from each account to reach your RMD. For example, if you have money in an IRA that isn't earning much and money in an IRA that's done well, you could take as much as you want from the weaker-performing one until you've met the minimum, assuming you want to make the weaker-performing one a less significant part of your investment portfolio. And if you set up a Roth IRA, you can take some of the funds you need to live on from the Roth as part of your yearly RMD without owing taxes.

However, please note that if you have more than one employer-sponsored plan, you'll need to withdraw the required percentage from each.

Where to find out more

There are more details to review, such as how to factor in the life expectancy of your spouse. You might want to first check the  IRS website on RMDs. Your professional tax advisor can also be a good guide for how to handle your RMDs.

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