All about required minimum distributions

SocialTwist Tell-a-Friend
Kevin McCormally

It’s a watershed year for the baby boom generation. In 2016, the first of the boomers — those born in the first half of 1946 — will reach age 70 1/2. Their present from Uncle Sam is a demand that they begin withdrawing funds from their traditional individual retirement accounts (IRAs) and employer-sponsored retirement plans, such as 401(k)s. 

If you’re among those at the head of this parade, you need to know the ins and outs of required minimum distributions (RMDs). If your parents or grandparents are the ones moving into RMD-land, do them a favor and share this with them.

The RMD calendar

If your 70th birthday falls between Jan. 1 and June 30, you’ll turn 70 1/2 in 2016, and you must take your first required distribution from your traditional IRAs. If your birthday is July 1 or later, your first RMD will come in 2017.

Generally, you must take RMDs by Dec. 31, but first-timers can wait to take their initial payout until as late as April 1 of the following year. So if you reach 70 1/2 in 2016, you can postpone your first withdrawal until 2017. But doing so means you’ll have to take two distributions in 2017.

Be sure to check whether that could push you into a higher tax bracket, cause more of your Social Security benefits to be taxed, or subject you to the Medicare high-income surcharge a couple of years later.

Note: The RMD rules do not apply to original owners of Roth IRAs. Because the government doesn’t get to tax Roth withdrawals, it doesn’t care whether you ever withdraw that money (although your heirs must take withdrawals).

Pinpoint how much to withdraw

You don’t need a computer or a degree in accounting to figure out how much you must withdraw from your IRAs. First, find the 2015 year-end balance of every traditional IRA you own. Second, add them together. Third, divide the total by a factor provided by an IRS table that’s based on your age and life expectancy.

For most IRA owners who turn 70 1/2 in 2016, the divisor is 27.4. So, for example, if your IRAs held a total of $500,000 at the end of 2015, your RMD for 2016 is $18,248. An IRA owner whose spouse is more than 10 years younger and the sole beneficiary of the account must use a different, larger factor. [See sidebar, “When you spouse is much younger.”]

Once you know how much you must withdraw from your IRAs, you can choose which accounts to tap. You can withdraw the total RMD from a single IRA, or spread the withdrawal over several accounts.

Slightly different 401(k) rules

Reaching age 70 1/2 also triggers required distributions for most 401(k) owners. But the rules aren’t exactly the same as for IRAs.

First, if you have more than one workplace retirement plan, you must figure the RMD for each account (based on the same life-expectancy factor that applies to IRAs), then withdraw separate RMDs from each account.

You can’t pick and choose which account to tap, as you can with IRAs. If you’re still working at 70 1/2 (and you don’t own 5 percent or more of the company), you can delay your first RMD until the year you stop working.

Most RMDs are taken in cash, but they don’t have to be. If you own stock or mutual fund shares you’d like to hold on to, for example, you can have the shares transferred to a taxable account. As long as the value of this in-kind distribution equals your RMD, you’ll be square with the IRS.

You’ll owe tax on the shares you transfer, just as if you had withdrawn cash. But your tax basis in the transferred securities — the amount you’ll use to determine the gain or loss when you ultimately sell them — will be the market value on the date of the transfer.

An in-kind distribution might make sense if, say, you own shares that have fallen in value but that you expect to recover. If you keep the shares in an IRA, any increase in value will be taxed in your top tax bracket when you ultimately pull the money out of the IRA. But if you move the shares to a taxable account and hold them for more than a year, any post-transfer appreciation will be treated as a tax-favored long-term capital gain, with a tax rate as low as 0 percent, depending on your other income.

Tax considerations

Most payouts from traditional IRAs are fully taxed in the year you withdraw them. But it’s clear from the tax form that that’s not always the case. If you have ever made a nondeductible contribution to your IRA, then part of every withdrawal will be tax-free.

That’s the good news. The bad news is that it’s up to you — not the IRS or the IRA sponsor — to know what’s what. You should have filed a Form 8606 with your tax return for each year you made a nondeductible contribution, and the most recent version should show the total of all your nondeductible contributions (minus any part that has been withdrawn).

That amount is your basis in your IRA, and you need to figure the ratio of the basis to the total in all your traditional IRAs. If your basis is 5 percent of the total, for example, then 5 percent of your withdrawal will be tax-free.

As a general rule, an IRA sponsor will withhold 10 percent of your payout as taxes to be sent to the IRS. But, unlike tax withholding on wages, this payment is completely voluntary. If you want to block withholding — or have more than 10 percent withheld — simply tell your IRA sponsor at the time you request the distribution.

Withholding tax on your RMD may simplify your life if it permits you to avoid making quarterly estimated tax payments during the year. Some IRA owners, in fact, use large withholdings from late-in-the-year RMDs to cover their tax bill on both the IRA payout and investment earnings. Such withholding can protect you from an underpayment penalty because withholding is considered paid evenly through the year, even if it comes in late December.

If you are withdrawing your RMD via monthly or quarterly payments from the IRA, you may need to file a Form W-4P with the sponsor to either block withholding or determine the amount to be withheld. If your state has an income tax, be sure to check on your state’s rules about tax withholding on IRA payouts.

What about penalties?

One of our tax laws’ most draconian penalties is reserved for those who fail to take as much out of their IRAs as the RMD rules demand. The penalty is equal to 50 percent of the amount you failed to withdraw. It’s as though Uncle Sam were saying that, if you don’t want the money, he will be happy to take it off your hands.

If you miss the RMD deadline, though, don’t automatically send a check to the IRS. The agency can, and often does, waive the penalty for taxpayers who have a good excuse — such as getting lousy advice from a tax preparer or IRA sponsor, or becoming seriously ill just before year-end when you had planned to make the required withdrawal.

If you think you have a good excuse, the IRS will review your case before making you pay the penalty. First, though, get the required amount out of your IRA as soon as possible, to show good faith. Then, figure the penalty on Form 5329, but don’t send a check. Instead, attach a statement to the form explaining why you failed to meet the deadline. If the IRS agrees that your request for a waiver is reasonable, you’re okay. Otherwise, you’ll get a bill.

Remember, the M in RMD stands for minimum. You can always take more out of your IRA than the RMD demands (although you’re probably best off leaving the money in the tax shelter until you need it).

And there is no requirement that you spend the money once it comes out of the account. You have to pay tax on the distribution, yes, but you can immediately reinvest it in a taxable investment account.

All contents © 2016 the Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.