What Retirees Should Know About Required Minimum Distributions

Traditional IRAs may allow for tax savings in the year of contribution as well as tax-deferred growth for many years to come. Unfortunately, traditional IRAs are also subject to the rules of required minimum distributions. Required minimum distributions are the IRS’s way of saying you have avoided paying tax for long enough.

Specifically, long enough in the eyes of the IRS is April 1 of the year following the year in which you turn 70.5 years old. This is the date at which your first required minimum distribution must be taken. If it is not, the penalty is punitive: 50% of what should have been distributed.

The First Required Minimum Distribution (RMD)

The first required minimum distribution for an IRA owner is due by April 1 of the year following the year in which you turn 70.5 years old. It is then required that you take a distribution every year.

From a practical standpoint, there is a choice when it comes to your first required minimum distribution:

  • Option 1 – Wait until April 1 of the year following the year you turn 70.5 to take your first distribution.
  • Option 2 – Take your first distribution in the year you turn 70.5.

The impact of your first distribution, as well as subsequent distributions, is simple.

If you choose option 1, you will be required to take two distributions in that calendar year, specifically, the one you “delayed” for the year in which you turned 70.5 and the annual distribution required for the new calendar year.

If you choose option 2, you will take one distribution in the year you turn 70.5 and one in the following calendar year (and every subsequent year).

How Much to Take

The amount of your required minimum distribution is based on two criteria: the total amount of your combined IRAs (and other qualified accounts) and your age. Specifically, the value used for calculating your annual RMD is the previous year-end balance.

Using a hypothetical example to illustrate, let’s assume you have a previous year-end balance in your IRA of $1,000,000 and you are 70.5 years old. Based on the RMD table provided by the IRS we can see a distribution factor of 27.4.

To calculate the required minimum distribution amount, we use a simple formula:

Previous Year-End Balance / Distribution Factor = RMD

In this scenario, the math is as follows:

$1,000,000 / 27.4 = $36,394.45

Every subsequent year following age 70, the distribution factor in the table becomes smaller. As the distribution factor becomes smaller, the required minimum distribution becomes larger. For illustrative purposes, let’s assume the above $1,000,000 IRA had an owner who was 80 years old. The distribution factor for an 80-year-old is 18.7.

$1,000,000 / 18.7 = $53,475.94

By age 90, the factor is 11.4, meaning a required minimum distribution for a $1,000,000 IRA would be approaching 10% of the account balance.

$1,000,000 / 11.4 = $87,719.30

The older you are, the more you are required to take, all else being equal.

Burst of Knowledge – For an IRA owner with a spouse who is the sole beneficiary and 10 years younger, you can use the joint life expectancy table for calculating RMDs.

What to Do with an RMD You Don’t Need

For some retirees, the required minimum distribution is often an amount that’s greater than what they need to meet their living expenses. To put it another way, if they had the option, they would likely prefer not to take the RMD.

Unfortunately, this is not an option. In fact, the penalty for not taking your RMD is high: 50% of what should have been distributed.

However, even though you are required to take an RMD, you are not required to spend it. In fact, it wouldn’t be uncommon for a retirement plan to be dependent upon saving your “excess” RMD for future use.

One common excess RMD strategy is to redirect the IRA distribution into a non-IRA investment account. By doing so, you are keeping your money invested in hopes of accumulating assets and savings for later.

Specifically, one could do the following:

A second option for an RMD you don’t need may be a qualified charitable distribution, meaning that you simply give it to charity.

The IRS allows for a tax-free charitable distribution of up to $100,000 per year from an IRA as long as certain conditions are met. One key required condition is the direct transfer from the IRA custodian to an eligible charity.

A qualified charitable distribution satisfies the required minimum distribution. Furthermore, it keeps the account owner’s adjusted gross income (AGI) lower than it would have otherwise been. This could potentially have a positive impact on the taxability of Social Security and the cost of Medicare. However, no deduction is taken on Schedule A for the charitable contribution.

Pre-RMD Planning

Once you reach 70.5 and RMDs begin, there is little planning that can be done to materially impact your annual RMD.

Prior to 70.5 years old, there may be several options. Roth conversions are one such opportunity to lower your RMD, and I am a big fan of these.

In lieu of Roth conversions, simple saving strategies may help. If you notice all your investments are currently IRAs, it may make sense to consider saving in a Roth IRA or a non-IRA investment account prior to age 70.5. In fact, more and more employers are now offering a Roth 401(k). In the years leading up to retirement, it may make sense to contribute to a Roth in lieu of a traditional 401(k), even if you are in your max earning years.

A third strategy could be to use a QLAC. A QLAC is a qualified longevity annuity contract. Qualified longevity annuity contracts involve taking a portion of your IRA balance and giving it to an insurance company. In exchange, the insurance company will pay you an income later in life. This strategy is intended to protect against living too long.

Generally speaking, I am not a big believer in this strategy as a way to lower your RMD.

Closing Thoughts on RMDs

Required minimum distributions take tax-deferred dollars and make them taxable. Unfortunately, they are a part of life.

For some retirees, RMDs are a non-event as distributions from IRAs will need to occur as a means of supporting a retirement lifestyle.

For others—those who don’t need the income—additional planning steps may be available to lower RMDs, strategize distributions, or plan efficiently for taking income. Ultimately, it’s these planning opportunities that should be considered well in advance of retirement in order to efficiently plan for both the present and the future.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.

None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.


, ,

No comments yet.

Leave a Reply