With final holiday preparations looming, the last thing anyone wants to think about is next April's tax bill. But if you're over 70 ½ and have any tax-deferred retirement accounts (like an IRA), put down the wrapping paper and listen up: IRS rules say that, with few exceptions, you must take required minimum distributions (RMDs) from your accounts by December 31 of each year – and pay taxes on them – or face severe financial penalties.
Here's what you need to know about RMDs:
Congress devised IRAs, 401(k) plans and other tax-deferred retirement accounts to encourage people to save for their own retirement. Aside from Roth plans, people generally contribute "pretax" dollars to these accounts, which means the contributions and their investment earnings aren't taxed until withdrawn after retirement.
In exchange for allowing your account to grow tax-free for decades, Congress also decreed that minimum amounts must be withdrawn – and taxed – each year after you reach 70 ½. To ensure these rules are followed, unless you meet certain narrowly defined conditions, you'll have to pay an excess accumulation tax equal to 50 percent of the RMD you should have taken; plus you'll still have to take the distribution and pay regular income tax on it.
You can delay or avoid paying an RMD in certain cases, including:
- If you're still employed at 70 ½, you may delay starting RMDs from your work-based accounts until you actually retire, without penalty; however, regular IRAs are subject to the rule, regardless of work status.
- Roth IRAs are exempt from the RMD rule; however, Roth 401(k) plans are not.
- You can also transfer up to $100,000 directly from your IRA to an IRS-approved charity. Although the RMD itself isn't tax-deductible, it won't be included in your taxable income and lowers your overall IRA balance, thus reducing the size of future RMDs.
Another way to avoid future RMDs is to convert your tax-deferred accounts into a Roth IRA. You'll still have to pay taxes on all pretax contributions and earnings that have accrued; and, if you're over age 70 ½, you must first take your minimum distribution (and pay taxes on it) before the conversion can take place.
Ordinarily, RMDs must be taken by December 31 to avoid the excess accumulation tax. However, if it's your first distribution you may wait until April 1 the year after turning 70 ½ – although you're still must take a second distribution by December 31 that same year.
Generally, you must calculate an RMD for each IRA or other tax-deferred retirement account you own by dividing its balance at the end of the previous year by a life expectancy factor found in one of the three tables in Appendix C of IRS Publication 590:
- Uniform Lifetime Table if your spouse isn't more than 10 years younger than you, your spouse isn't the sole beneficiary or you're unmarried.
- Joint and Last Survivor Table when your spouse is the sole beneficiary and he/she is more than 10 years younger than you.
- Single Life Expectancy Table is for beneficiaries of accounts whose owner has died.
Although you must calculate the RMD separately for each IRA you own, you may withdraw the combined amount of all RMDs from one or more of them. The same goes for owners of 403(b) accounts. However, RMDs required from other types of retirement plans must be taken separately from each account.
To learn more about RMDs, read IRS Publication 590 at www.irs.gov.
Jason Alderman directs Visa's financial education programs. To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney