The IRS allows you to build up a sizeable nest egg for retirement inside your traditional IRAs. But then the other shoe drops: Whether you want to or not, you must begin taking “required minimum distributions” (RMDs) once you reach a certain age. Otherwise, you could be socked with a hefty tax penalty.
But the tax law does provide some flexibility. Depending on your situation, you might decide to withdraw funds from one of your IRAs, all of your IRAs, or any combination you prefer.
You have to start taking RMDs from your IRAs by April 1st of the year after the year in which you turn age 70½. In other words, if your 70th birthday was on June 1, 2012, you must take an RMD for the 2012 tax year by April 1, 2013. Then you still have to take another RMD for the 2013 tax year by December 31, 2013.
The amount of the RMD is based on the value in your accounts on December 31st of the tax year and is calculated according to IRS-approved life expectancy tables. For example, if you have a total balance of $1 million in your IRAs and your age is 76, the distribution period under the life expectancy table is 22 years. Divide $1 million by 22, and you arrive at an RMD of $45,454.55 for the current tax year.
The penalty for failing to take a timely RMD is equal to 50% of the required amount of the distribution (minus any distribution you actually received). Going back to our example, suppose you’ve taken an RMD for 2012 of $20,454.55, or $25,000 less than the required amount. In this case, you would owe a penalty of $12,500 (50% of $25,000) on top of the regular income tax. If you’re in the 35% tax bracket in 2012, that’s a whopping total of $28,409 ($15,909 + $12,500)!
Comparable rules apply to tax-deferred earnings within a tax-qualified retirement plan such as a 401(k). But you may postpone RMDs from qualified plans (not IRAs) if you continue working past age 70½ as long as you don’t own more than 5% of the company that employs you.
The amount of your annual RMD reflects the value of all your IRAs, but you can actually withdraw the funds from one or more of the IRAs. If you’re maintaining separate IRAs with different beneficiaries, you might want to keep the balances in all of them equal—and they may have gotten out of whack because of withdrawals, contributions, fees, and investment performance. So, for instance, if you have three IRAs and you’ve designated a different beneficiary for each one, you could withdraw the entire RMD amount from the IRA with the highest balance. Or you could get rid of underperforming assets in one of your accounts by liquidating those to provide cash for the RMD.
Keep in mind that you must give explicit instructions about your RMDs to each IRA custodian, and please call us if you have any questions.