Remember that old fable about the ant and the grasshopper, in which the grasshopper spent his summer days frolicking while the ant toiled away, storing up grain for the lean times ahead? The human equivalent of the ant is the person who carefully saves up for retirement, rather than spending every dollar that comes in.
If that's you, congratulations! You won't be like the worried grasshopper when the winds turn cold. But imagine that that diligent ant, despite his best efforts, lost big chunks of his hard-earned savings, just because he took the wrong number of grains out of his storehouse, or took the right number out at the wrong time. It doesn't seem fair—but that's exactly what can happen to you, if you run afoul of Required Minimum Distribution (RMD) rules with your IRA.
The IRS requires people with traditional IRAs to withdraw at least a certain amount from their IRA (and certain other employer-sponsored retirement accounts, but not Roth IRAs) each year beginning in their early seventies. These are known as Required Minimum Distributions.
Unfortunately, these RMDs, brought to you by the folks who wrote the federal tax code, are not always easy to figure out. Even more unfortunately, your failure to comply precisely with the rules can cost you dearly. Distributions from traditional IRAs are taxable, so if you take out more than you need to, you're taking a payment you may not need, and paying more taxes than you should have to. Even worse is if you take out too little: the IRS will penalize you, as much as 50% of the amount you should have withdrawn, but failed to. Those dollars you faithfully tucked away for the lean years? Snatched away by the federal government.
If you think figuring out the right RMD and the right time to take it is like trying to thread a needle in a hurricane, you're not alone. Here are some pitfalls to watch out for when making your RMDs.
You probably know that you need to begin taking distributions when you turn 70 1/2. Many people think that means that you must take this distribution as soon as you turn 70 1/2, whether you need the funds then or not.
In actuality, IRS rules require you to take that first RMD by April 1 of the year following the year you turn 70 1/2. So if your birthday is August 1, and you turn 70 1/2 on February 1, 2017, you must take your first RMD by April 1, 2018.
So you may be able to delay that first RMD for several months or over a year, but should you? It depends. If you do wait until the last possible moment, say, March 30 of the calendar year after the calendar year in which you turn 70 1/2, be mindful of when you need to take your next one: before December 31 of that year.
So you may be able to delay that first RMD for several months or over a year, but should you? It may be wiser to take your first RMD before December 31 of the year in which you turn 70 1/2, in order to avoid double distribution and taxation the following year.
That translates into two distributions in the same calendar year, which will raise your taxes that much more. It may be wiser to take your first RMD before December 31 of the year in which you turn 70 1/2, in order to avoid double distribution and taxation the following year.
One possible exception? If you are planning to retire in the calendar year following the year in which you turn 70 1/2. In that case, because of your retirement, your tax rate may be lower, so you could end up paying less tax on those RMDs.
Okay, you've decided when to take those first RMDs; now how much do you have to take? Your RMD depends in part on the value of your account, but account values fluctuate. If you use the wrong valuation date, you take the wrong RMD. This simple error has proved costly for many people. The valuation date you need to use is December 31 of the year prior to the distribution—NOT the distribution date.
Another factor on which your RMD is based is your life expectancy. Well, your life expectancy goes down every year, as your age goes up, naturally. But many people forget to make this adjustment when calculating their RMD. The IRS publishes life expectancy tables for the purpose of annual recalculations of RMDs.
You need to calculate the RMD separately for each IRA and each employer-sponsored account to which the RMD applies. To make matters worse, RMD rules are different for different types of accounts.
If these cautions have made you reluctant to calculate your own required minimum distributions, don't feel bad. You're not alone, and we often encourage clients to get the assistance of a tax professional when calculating RMDs. Professional guidance in this process is a worthwhile safeguard against a higher tax bill or IRS penalties.
If you'd like to learn more about IRAs and required minimum distributions, we invite you to contact us. We can work together with your financial and tax professionals to maximize your tax planning opportunities.