How to Avoid a 50% Mistake
December 18, 2013Every year, the Ward family gathers around the table to share a traditional Thanksgiving meal together. Each of us takes turns sharing what we are thankful for and before long, the whole dining room is alive with laughter and joyous conversation. After the kids are excused, the adults sit closer together to talk about more serious issues, and inevitably the subject of money enters the discourse. Fortunately, there is a financial planner among them, so everyone knows who to ask when financial questions arise.
This year’s questions arose from a letter my uncle received at the beginning of the year. The letter stated that a certain amount of money had to be withdrawn from his retirement account before April 1st of next year. Right away, some of you know what I’m talking about but for the rest of you, it may help to know that my uncle turned 70 ½ this year.
The letter was from my uncle’s IRA custodian and was a reminder that this year was the first year he was subject to required minimum distributions. Required minimum distributions, or RMDs for short, are the IRS’s way of making sure income taxes are paid on tax-deferred money. Once RMDs begin, traditional IRA owners are required to distribute a portion of their account each year until the account is depleted or inherited by a beneficiary.
Here is what everyone around the dinner table wanted to know:
A: Because my uncle has money in a traditional IRA and he turned 70 ½ this year. If you own a traditional IRA or if you have money in a 401(k) or similar employer-sponsored retirement account and are no longer employed, then congratulations, you’re subject to RMDs. The IRS requires RMDs to begin when you turn 70 ½ (but please don’t ask me why).
Q: If RMDs begin when he turns 70 ½, then why does he have until April 1st of next year to take the distribution for this year?
A: Because this is his first one. Usually RMDs are required by December 31st of each year, but the IRS makes an exception for the first RMD, allowing the taxpayer until April 1st of the following year to make the distribution. Deferring the distribution until next year may be advantageous if my uncle expects to be in a lower bracket next year, but it has the disadvantage of having two distributions occur in the same tax year. My uncle does not HAVE to wait until April 1st to make the first distribution; he just has that option.
Q: How is the amount he is required to distribute calculated?
A: The amount he is required to distribute is calculated by taking his account balance as of the end of the prior year and dividing it by a distribution factor. The distribution factor used will be based on his age, along with the age and relationship of his beneficiary. Fortunately, his IRA custodian (and 401(k) administrator, if applicable) will calculate this amount for him, but here is an example of how it works:
Let’s say my uncle’s IRA balance was $274,000 on the last day of 2012. Because he is single, he will use the distribution factor found in Table III in Appendix C of IRS Publication 590. His distribution factor will be 27.4 since he will still be 70 on the last day of 2013. Therefore, his 2013 RMD is $10,000 ($274,000 / 27.4), and he will have until April 1st to distribute at least that amount. You can calculate the amount of your RMD by using the RMD worksheets found on the IRS website.
Q: What if he has more than one retirement account?
A: Good question. He can withdraw the total amount of his IRA RMDs from any one or more of them. For example, if the RMD for one IRA is $1,000, and the RMD for another is $10,000, he may take $11,000 from either account. However, RMDs from other plans like 401(k) and 457 accounts must be taken separately from each account.
Q: What happens if he fails to take his RMD on time?
A: If he doesn’t take his RMD on time, he will be charged 50% on the deficiency. Using the example above, if he takes $1,000 from his IRA but forgets to withdraw another $10,000 before the deadline, he is looking at a $5,000 penalty. Ouch!
Q: What about Roth accounts?
A: Roth 401(k) accounts are subject to RMDs the same as traditional retirement accounts. However, Roth IRAs are NOT subject to RMDs. If he has money in a Roth 401(k) but doesn’t want the balance included in the RMD calculations each year, then he should consider rolling it over to a Roth IRA. He just needs to be aware that an RMD distribution will be taken from the account prior to rolling it over because he’s already reached his required beginning date.
Q: What if he doesn’t need the money?
A: Well, just because he is required to distribute it doesn’t mean he is required to spend it. He can’t roll it over to another retirement account, but he can deposit the money in a savings or investment account. If he’s worried about the tax implications and is charitably inclined, he can make a qualified charitable distribution (QCD) for 2013. He just needs to hurry up and do it before the end of the year.
I don’t know if it was the turkey dinner or the conversion, but at this point everyone was starting to doze off. It may not have been the liveliest of topics, but it sure gave me something to write about. If you’d like to learn more about RMDs, visit the IRS website.