In an effort to encourage workers to save for retirement, the United States government allows individuals to save part of their income tax-deferred into retirement accounts. Workers do not have to pay taxes on these funds or on the investment gains until the money is withdrawn from the account as income, usually during retirement.
While tax-deferred accounts are a great savings tool for retirement, the government does want to eventually get paid, so it requires owners of these accounts take annual Required Minimum Distributions (RMDs) once the account owner reaches the age of 70½.
Generally, individuals are required to start taking withdrawals from accounts such as an IRA, SEP IRA, Simple IRA or a company sponsored retirement plan such as a 401(k) once they reach age 70½. Workers still employed may be able to postpone RMDs from a retirement plan with their current employer until retirement. Individuals must begin RMDs at 70½ for IRAs and if the account owner owns 5 percent of the business sponsoring the retirement plan, even if the individual is still working.
Individuals must take RMDs for the year he or she turns 70½, but they can delay taking that first distribution until April 1 of the following year. All subsequent RMDs must be taken by December 31 of each year. As an example, if someone turns 70½ in May of 2019, that individual will have until April 1, 2020 to take the RMD for 2019. The individual will then have until December 31, 2020 to take the RMD for 2020.
Taxes on the distributions will be owed for the tax year in which the funds were received. Individuals can have state and federal taxes automatically withheld from the distributions, which can help prevent a large tax bill come tax season. Distributions can also be taken periodically throughout the year and don’t necessarily have to be taken in a single lump sum. Also, if the individual doesn’t need the income from the distributions immediately, the after-tax funds can be reinvested in non-qualified accounts. Taxes on any subsequent gains from reinvesting will need to be paid when the gains are realized.
The IRS defines age 70½ as six calendar months after an individual’s birthday. For example, if an individual turns 70 on June 30, 2019, that person would reach 70½ on December 30, 2019 and would be required to take the distribution for 2019 by April 1, 2020. They would also be required to take the 2020 distribution by December 31 of 2020. A person who turns 70 on July 1, 2019 would reach 70½ on January 1, 2020 and would not have to take a distribution for 2019. They must take the distribution for 2020 by April 1, 2021, and then would have to take the distribution for 2021 by December 31, 2021.
The annual RMDs are calculated by taking the preceding year’s end-of-year balance in the retirement account and dividing that amount by a distribution period from the IRS Uniform Lifetime Table. The table is based on an individual’s age. The distribution period at age 70 is 27.4 and decreases (increasing the percentage of the distribution that needs to be taken each year) as the individual gets older. More information on the table and the distribution worksheets to calculate the annual distributions can be found at https://www.irs.gov/retirement-plans/plan-participant-employee/required-minimum-distribution-worksheets.
Individuals holding multiple IRAs must calculate the RMDs for each account separately, but they can generally choose to take the distribution from a single IRA or from a combination of the accounts. For qualified retirement plans or inherited IRAs, the distributions must be calculated separately and taken from those respective accounts. Distributions are not required for Roth IRAs since those accounts are initially funded with after-tax dollars.
Penalties for failing to take RMDs could include a 50 percent excise tax on the amount not taken or distributed late. An individual may also be required to file Form 5329 to report the excise tax. Keep in mind there are also additional rules and calculations for RMDs in special situations. The rules apply to beneficiaries of inherited IRAs in the event the account owner passes away or if a spouse is 10 years younger than the account owner and is the sole beneficiary of the account. Please refer to your tax specialist or your Financial Planner for more information on RMD guidelines.