Understanding taxes come retirement time
The primary benefits of retirement savings accounts such as traditional IRAs and employer-sponsored plans are tax-deductible contributions and tax-deferred growth. Tax-deductible contributions allow those individuals who qualify to reduce the size of their current tax burden while they are saving for retirement — which effectively lets them save more. Tax-deferred growth allows funds inside these accounts to grow without concern for an annual tax bill on that growth.
All good things must come to an end however, and the IRS must eventually be paid. The tax benefits of these accounts are provided for one purpose: to help individuals save for retirement. Therefore, once an individual reaches retirement age, the same rules that provided the benefits now dictate that the funds must be used for retirement purposes and the taxes that have been avoided must be paid.
The federal government has created a set of rules that require a minimum amount of money that must be withdrawn (distributed) from these accounts each year, starting at a specific age (usually 70 1 ⁄2, but more on this later). These required minimum distributions are often referred to as RMDs. You can always withdraw more than the minimum amount from your IRA or other qualified plan in any year, but if you withdraw less than the required minimum (or take it too late), you will be subject to a federal tax penalty. The penalty is a 50 percent excise tax on the amount by which the RMD exceeds the distributions actually made to you during the year. This is in addition to any income taxes owed on the amount of the distribution, as distributions from IRAs and qualified plans are taxable as ordinary income.
The RMD rules are calculated to spread out the distribution of your entire interest in an IRA or plan account over your lifetime. The purpose of the RMD rules is to ensure that people don’t just accumulate retirement accounts, defer taxation and leave these retirement funds as an inheritance. Instead, required minimum distributions generally have the effect of producing taxable income during your lifetime.
The amount that is required to be distributed is determined by a special calculation that, in essence, takes the total amount in the account and divides it by the number of years the individual is expected to live. The account value for RMD purposes is the account balance as of Dec. 31 of the prior calendar year.
The life expectancy factor (or distribution period) for most taxpayers will be determined using the Uniform Life Table. This will apply to account owners who are unmarried, those who are married and their spouse is not more than 10 years younger than themselves, and those who are married and their spouse is not their sole beneficiary.
The notable exception to this is the account owner who has a spouse who is the sole beneficiary of their account and the spouse is more than 10 years younger than themselves. In this instance, the owner may base the calculation of their RMD using the longer joint and survivor life expectancy for themselves and their spouse. Life expectancy factors can be located in IRS publication 590.
As previously mentioned, generally your first required minimum distribution from an IRA or retirement plan is for the year in which you reach 70 1 ⁄2 years of age (required beginning date). However, you do have some degree of flexibility with when you take your firstyear distribution. You can take it in the year in which you turn 70 1 ⁄2 or you may delay it until April 1 of the following year. Required distributions for all subsequent years must be taken by Dec. 31 of each calendar year until the owner dies or the account balance is reduced to zero.
Be aware that the option to delay your first RMD should be considered very carefully, as if you decide to do so, you will end up taking two RMD’s in the same calendar year.
It should also be noted that the exception to the 70 1 ⁄2 years of age rule is for those who work past the age of 70 1 ⁄2 and are still participating in an employer-sponsored plan. In their case, they may use the year in which they retire as the required beginning date. This only applies to their employersponsored plans, not their IRAs.
Given the complex and frequently changing nature of tax law, individuals faced with the need to make required distributions from IRAs or qualified retirement plans should seek the guidance of qualified professionals. The penalties for a mistake in this area are far too high to take chances. Either make sure you understand the rules and how to comply with them or engage the services of someone who does.