Understanding IRA minimum withdrawal rules

Did you know: Once you turn 70 ½, you are required to make your first minimum withdraw from your traditional IRA.

Even if you don’t need your savings for living expenses, you are still required by law to start taking out required minimum distributions (RMDs) by the following April 1 after you turn 70 ½. This is mandatory for all traditional IRAs and employer-sponsored retirement accounts — but not Roth IRAs.

According to Clay Hartman, Partner and Senior Wealth Advisor at Frontier Wealth Management, it’s important to understand regulations when you near this age so you can find your best RMD solution.

“Your mandatory withdraws from your IRA must be included in your taxable income for the year, so it’s important to have a solid financial plan in place when it comes to RMDs,” Hartman says. “Some individuals who are on the threshold between tax brackets can find themselves pushed into upper ranges due to their new taxable income, causing higher tax rates for Social Security and added Medicare costs.”

To help avoid higher costs and increased tax brackets, Hartman has two suggestions: consider converting your traditional IRA to a Roth IRA sooner or donate your RMD (which avoids adding it to your taxable income). You can also start taking it out sooner than the deadline to avoid higher RMD amounts.

How do I calculate my RMD?

The custodian of your IRA should provide your RMD amount or offer to calculate it for you upon request. How much you have to withdraw depends on the balance of your IRA account, divided by a life-expectancy figure from the IRA. Meaning that every year, your amount changes based on your age.

For example, if you turn 70 in 2018, your first RMD will have to be paid April 1, 2019. The IRA’s life expectancy for a 70-year-old is 27.4. Let’s say your IRA account balance is $500,000. Using those two numbers, we can figure out your 2019 RMD:

500,000 ÷ 27.4 = $18,249

If that’s all you take out in 2019, your 2020 balance will be around $482,000 (assuming no growth). You will then use the IRS table again for your age (71) and find your 2020 life expectancy number (26.5). Your 2020 RMD calculation is:

482,000 ÷ 26.5 = $18,189

You will be required to do this annually for every traditional IRA that you have in your name. Note that the included RMD table doesn’t apply to you if your spouse is the sole beneficiary of your IRA and is at least 10 years younger than you. You will have a different table for this.  That said, it is always a good idea to consult your IRA custodian or financial advisor when calculating your RMD.

Why is there a federal RMD?

In short: The federal government wants its share of your IRA sooner rather than later. While your money is in your IRA, you don’t pay any taxes on it; you only pay taxes when you withdraw.

What if I don’t want to withdraw my RMD?

You’ll have to pay a pretty big tax penalty (50 percent) on the RMD if you fail to pay it for a year. If you happen to miss your deadline, you can fill out the IRS Form 5329 to explain what happened. The IRS may waive your penalty if due to a “reasonable error,” such as an illness or change of address.

Hartman says there are alternatives if you don’t want to take out your money because you’re not sure where to put it.

“There are no rules surrounding where you spend your RMD. You actually have a variety of options that can potentially benefit you and those around you, depending on your financial needs and personal goals.”

Hartman suggests these options as a few ways you can use your RMD for good, either for you or your community:

Invest

You can’t reinvest your RMD back into tax-advantaged retirement accounts but you can put them into taxable brokerage accounts such as municipal bonds, tax-managed stock mutual funds, or most stocks.

Set up college/inheritance funds

You can use your RMD to fund a tax-free 529 college savings or Roth IRA for Kids account. You can also convert some of your traditional IRA assets to a Roth IRA, through which your beneficiaries can inherit income tax-free (as long as the distributions are qualified).

You can do a qualified charitable distribution (QCD) directly from your IRA, up to $100,000 per year. If you’re a high-income earner, this can be advantageous because it does not count against your limits on deductions for charitable contributions and is not included in your gross income.

Conclusion

Having to take out a high RMD is a pretty good problem to have, Hartman says, because it means you are doing well with your savings. But, understanding federal regulations and your options can help you plan for retirement — before your first large withdraw happens — in order to avoid costly mistakes or surprising tax increases.

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