The Qualified Plan Rules
- Participants in qualified retirement plans such as 401K, SEP, Defined Contribution and Defined Benefits plans and most Individual Retirement Accounts (IRA) or annuities (IRAs) cannot enjoy tax-deferred earnings indefinitely. Eventually, they must begin taking required minimum distributions (RMDs) from their accounts every year.
- Generally, the latest date for taking the first RMD is April 1 of the year following the year in which the account owner reaches age 70½. However, participants owning 5% or less of the company maintaining an employee retirement plan can delay their first RMD date until April 1 of the year following the year they actually retire, if later than age 70½. Postponement until actual retirement is not available to IRA owners.
- It may be prudent to take the first RMD by December 31 of the year the account owner reaches age 70½. An account owner who delays taking the first RMD until April 1 of the following year must take the second RMD no later than December 31 of the same year. Taking two RMDs in the same tax year may not be the most advantageous way to take distributions from these accounts.
- Failing to take an RMD generates a hefty penalty tax of 50% of the amount that should have been withdrawn. For example, an owner who should have withdrawn a $40,000 RMD but instead took only $30,000 would owe a $5,000 penalty (50% of the additional $10,000 the owner should have taken but didn’t).
- An owner always has the option to withdraw more than the required minimum.
The Complete Tax Picture
- The owner of a traditional IRA or a participant in an employer-sponsored retirement plan must include RMDs in gross income as they are paid out.
- The owner of a Roth IRA may generally withdraw contributions tax free at any time if the account has been held for at least 5 years and the withdrawal is made after age 59½. If the withdrawal is made before the 5-year period or age 59½, income taxes and a 10% penalty tax may apply. There is no such rule or requirements apply to Sec 7702 plan using life insurance cash value.
- Any tax basis included in the distribution is received tax free. However, IRA owners or participants in a company retirement plan will generally not have a tax basis unless they: (1) made nondeductible IRA contributions, (2) made after-tax contributions to their employee retirement plan accounts, (3) elected to deem a portion of their deferrals as Roth deferrals (if allowed under the plan), or (4) reported a yearly taxable economic benefit for life insurance provided through a retirement plan account.
The Annual RMD Amounts
- Owners who don’t need the withdrawals to maintain a standard of living often prefer to keep distributions as low as possible, deferring taxation and enjoying continued compound earnings on funds remaining in the account.
- The IRS provides a table of factors—the Uniform Lifetime Table—that is used to make the annual RMD calculation in most situations, based on the owner’s age.
Potential Survivors of IRA & Qualified Plan Account Owner
- If a spouse is more than 10 years younger than the owner and would be the sole beneficiary of the account at the owner’s death, the Joint Life Table (rather than the Uniform Lifetime Table) is used to calculate RMDs during the owner’s life.
- Use of the Joint Life Table results in lower RMDs during the owner’s lifetime, keeping more in the account to benefit a spouse who may outlive the owner by many years.
- After an account owner’s death, survivors must continue to take RMDs to avoid the 50% penalty tax.
The Bottom Line
The rules for required minimum distributions—particularly post-death RMDs—are complex and should be reviewed with a trusted advisor. In determining a strategy, a key objective is often to keep each year’s distribution to the minimum amount required—particularly in situations where maximum distributions are not needed to maintain a standard of living. This avoids the tax penalty while retaining more in the account to enjoy continued tax deferment and compound earnings.
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