How The RMD Laws Could Rock Your 401(k) Or IRA In Retirement

If you are in your 60s and own a 401(k) or IRA account (or both), you need to know about the RMD rules that take effect shortly after you turn 70.

RMD stands for "Required Minimum Distribution". It is the amount you must withdraw from your tax-deferred (or pre-tax) retirement accounts each year once you turn 70 years and 6 months of age (no idea why the IRS uses your half birthday and not age 70 or 71). The RMD rules are government's way of saying you have delayed paying taxes for too long and must begin recognizing your 401(k) and IRA savings as taxable income.

How RMDs work: The IRS provides two different age charts. One of them will apply to you. Your age on the appropriate chart will correlate to a "life expectancy factor", which you divide into the total value of all tax-deferred retirement accounts you own. The result is what you must withdraw for the year and recognize as ordinary income in your tax return. Each subsequent year you look up your new age and divide the corresponding factor into your year-end account balance. This life expectancy factor declines every year. The IRS presumes that your accounts are shrinking throughout retirement, so the life expectancy factor/divisor goes down to proportionally reflect that.

Beware... the first year is tricky! Pay close attention in whatever year you turn 70.5 years old. Your very first RMD must be taken by April 1 of the year after you turn 70.5. Every year after that the deadline is Dec. 31.

Why is the first RMD deadline different? Likely because most retirees are unaware that the RMD laws even exist, so the IRS gives you a grace period out of the gate. However, not only must you take the first RMD by April 1, but you must also take the second RMD by Dec. 31 of that same year (again, the year after you turn 70.5). So the first year is unique because it requires that you take not one, but two separate RMDs.

Let's put pen to paper and work through an example. Assume you turned age 70.5 on July 12, 2017. Here are the deadlines for your first few RMDs:

Year 1, taken by April 1, 2018 = (Balance on Dec. 31, 2016) / (Factor for age 70)
Year 2, taken by Dec 31, 2018 = (Balance on Dec. 31, 2017) / (Factor for age 71)
Year 3, taken by Dec 31, 2019 = (Balance on Dec. 31, 2018) / (Factor for age 72)
Year 4, taken by Dec 31, 2020 = (Balance on Dec. 31, 2019) / (Factor for age 73)

It is important to note that each year's RMD calculation requires that you go back and sum your previous year-ending account balances, since Dec. 31 is when your RMD is based on.

What if I don't take my RMD? This is where the IRS cleans up... You will be penalized 50% of whatever amount you were supposed to withdraw but did not. So if your RMD is $10,000 and for whatever reason you only withdraw $2,000 the IRS will penalize you 50% on the $8,000 you failed to withdraw, which means an additional $4,000 tax penalty!

How do I avoid RMDs? The best way to avoid taking RMDs is to convert a portion (or all) of your tax-deferred funds into Roth IRA funds prior to age 70. RMD rules do not apply to Roth IRAs. Of course, whatever balance you convert to a Roth IRA must be recognized as income, so you are paying Uncle Sam one way or another. However, performing a Roth IRA conversion does mean avoiding the administrative hassle of calculating RMDs during retirement and it also means future tax-free growth (the biggest Roth IRA perk of all).

A Roth IRA conversion could also mean cheaper Medicare Part B premiums in retirement too. The higher your income is, the higher your Medicare premiums are. Roth IRA withdrawals are not considered income, since those funds have already been taxed.

I often recommend doing Roth IRA conversions in chunks as you approach 70 so that you spread out the tax burden over multiple years. Even better, if you anticipate a year or two where your income will be unusually low, that would be a good time to convert to a Roth IRA because your income tax rate would be lower than normal. One example of this would be if you have stopped working, and are living off savings for a while rather than taking Social Security or receiving sizable pension payments (if applicable).

Can I apply 401(k) or IRA withdrawals taken before age 70 toward future RMDs? No, you cannot.

If I take more than my RMD for the year can I apply the excess toward next year? No, you cannot. There is no future RMD benefit for withdrawing more than the mandated amount in any given year.

Do I combine my spouse's accounts with mine? No, you calculate your RMD based on your age and he/she uses their age to calculate theirs. If your spouse has yet to turn age 70.5, they do not need to take a RMD.

What if I have a Roth 401(k)? The RMD rules apply to Roth 401(k) accounts, despite the fact they are funded with after-tax dollars and grow tax-free. An easy solution is to rollover your Roth 401(k) to a Roth IRA and avoid this mess altogether.

If I plan to spend the money in retirement anyway, what's the big deal? In fairness, RMDs may not pose a huge problem. But for many clients and others we know, the RMD rules have forced them to take out more than they want or need in their 70's. This has resulted in a larger tax bill than they prefer to pay, not only because they are recognizing more income that is subject to taxation, but because that extra income kicks them into a higher tax bracket to boot. They can no longer benefit from the tax deferral shelter that their 401(k) or IRA reaped for years and years.

There are other adverse situations that can arise too stemming from the RMD laws. For a more comprehensive list, feel free to contact us. The RMD rules are very real, very annoying and very costly if disregarded. Make sure you plan ahead!



Brian E Betz, CFP®