The rules for required minimum distributions—particularly post-death RMDs—are complex and should be reviewed with a financial professional. 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.
Participants in tax-deferred employee retirement plans and most IRAs (SEP, SIMPLE and traditional)cannot accumulate tax-deferred earnings indefinitely. Eventually, they must begin taking required minimum distributions (RMDs) from their accounts. Failure to do so will add a 25% penalty tax to the amount that they should have withdrawn, but did not (10% if the distribution error is corrected quickly).
Example: An account owner reaching the required age needs to withdraw $40,000 from the account to comply with RMD rules, but only takes out $30,000. The result is a penalty tax of $2,500 (25% of the $10,000 the owner failed to take)
RMDs must begin by April 1 of the year following the year in which the owner reaches age 73. It maybe prudent to take the first RMD by December 31 of the year the account owner reaches age 73. An account owner who delays taking the first RMD until April 1 of the following year must still take the second RMD by December 31 of the same year. Taking two RMDs in the same tax year may be disadvantageous.
An exception: employees owning 5% or less of the company maintaining the retirement plan can typically delay their start date until April 1 of the year following the year they actually retire, if that is later than age 73. Postponement until actual retirement is not available to IRA owners.
RMDs are included in the taxpayer’s gross income when they are paid out, with a tax-free recovery of basis if part of the distribution reflects an investment made with after-tax dollars. Usually, however, there will be no tax basis in the account unless the owner made nondeductible contributions or reported a yearly taxable economic benefit for life insurance provided through the agreement.
Account owners who don’t need distributions to maintain a standard of living usually prefer to leave as much in their accounts as possible.
To determine how much must be withdrawn annually to comply with RMD rules, the IRS provides a series of numeric factors in its Uniform Lifetime Table. The factor for the owner’s age is divided into the account balance at the end of the preceding year, with the result reflecting the RMD in most (but not all) situations.
Example: At age 75, the factor in the Uniform Lifetime Table is 22.9. If the owner’s account balance on the preceding December 31 was $1 million, the required minimum distribution would be$43,668.12.
If the account owner has a spouse who is more than 10 years younger and the sole beneficiary of the account, the Joint Life Table may be used instead of the Uniform Lifetime Table to calculate RMDs during the owner’s life. This generally creates lower RMDs during the owner’s lifetime, keeping more in the account to benefit a spouse who may survive the owner by many years.
After an account owner’s death, survivors must continue to take RMDs from the account to avoid the 25% penalty tax. “Eligible Designated Beneficiaries” (surviving spouses, minor children, beneficiaries not more than 10 years younger than the decedent, and those disabled or chronically ill) may take RMDs over their remaining lifetimes. All other beneficiaries must withdraw the entire amount within 10 years of the account owner’s death (although no RMDs are required during that time).
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This material was prepared by PGI Partners, Inc. on behalf of LPL Financial, LLC.
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