5

Required Minimum Distribution Rules

There was a time when a fool and his money were soon parted, but now it happens to everybody.

— Adlai Stevenson

Main Topics

• An overview of the Required Minimum Distribution rules (RMD)
• How to calculate your RMD
• An explanation of the IRS tables
• A possible compromise for taxpayers who don’t need their RMD for income
• How to get your interest-free loan from the IRS

KEY IDEA

If you can afford it, take only the minimum the government requires you to withdraw from your retirement plan or IRA. This distribution pattern retains more money in the taxdeferred account and is consistent with our motto, “Don’t pay taxes now—pay taxes later.” Note that after taking the Required Minimum Distribution, you can always withdraw more money should the need arise.

Eventually Everyone Must Draw from Retirement Savings

Even if you stick to the game plan to spend your income and after-tax dollars first, eventually, by law, you will have to withdraw funds from your traditional IRA or qualified retirement plan (Required Minimum Distributions (RMDs). Roth IRAs are currently exempt from this requirement, but that may change if President Obama has his way. For now, though, I will limit the discussion to the rules governing traditional retirement plans.

You will usually be required to take the annual RMD by April 1 of the year following the year that you reach age 70½. The key word here is minimum. Keeping in mind the “Don’t pay taxes now—pay taxes later” rule of thumb, I want you to continue to maintain the highest balance in your IRA. If you take a RMD the year you turn 70½ and a distribution the following year, you may remain in a lower tax bracket which would be advantageous. You can always take out more if you need it.

Eventually, by law,
you will have to
withdraw funds from
your traditional IRA or
qualified retirement
plan.

During the financial crisis of 2009, the federal government temporarily suspended the RMD rules. The reasoning was that older retirees shouldn’t be forced to sell their investments when the value of the investments is low. That reasoning didn’t make sense to me because investors have always been allowed to take their RMD in stock instead of cash, if they prefer – it’s called an in-kind distribution. So, if the investments in your IRA have decreased in value, you can have the investment shares transferred directly to a non-IRA account, and leave them alone until they increase in value again. You still have to pay tax on the amount of the transfer, but the only reason you would be forced to sell when the value is low would be if you did not have a lot of cash on hand, and need to sell some of the securities to pay the tax on the RMD. Another point to consider is that, while the IRS requires that you calculate the RMD for every IRA account that you own, you are not required to withdraw a minimum distribution amount from every IRA you own. You can add up all of your RMDs and take the total amount from one account, preferably from one that has not gone down in value. Hopefully, being aware of these little-known rules will help you avoid having to take a loss on your investments if you need to take a RMD when the markets are down.

Calculating Your RMD after Age 70½

Currently, RMDs are calculated by taking your projected distribution period, based on your age and the age of a beneficiary deemed to be 10 years younger than you, and dividing that factor into the balance of your IRA or qualified plan as of December 31 of the prior year. Bear in mind that your projected life expectancy factor or the projected distribution period is not based on your personal eating and exercise habits or even your genetic history! It is an actuarial calculation from the IRS determined solely by age. Many large financial institutions offer tools on their websites that automatically calculate RMDs. If you would like to do the math yourself, the IRS’s Supplement to the Publication 590 contains worksheets that you can use to work through the calculation, as well as the tables that you will need to use to find your RMD factor. For those who would just like a quick glance, the tables are published in the appendix at the end of this book.

The IRS provides three life expectancy tables. The most frequently used table is Table III, not Table I. I present them here in the reverse order.

1. Table III: Uniform Lifetime Table (for use by unmarried IRA owners and married owners whose spouses are not more than 10 years younger). This table is available in the appendix of this book.

2. Table II: Joint Life and Last Survivor Expectancy Table (for IRA owners with spouses 10 or more years younger). This is not covered in the appendix of this book because it is too long. See IRS Publication 590.

3. Table I: Single Life Expectancy Table (for IRA beneficiaries). This table is available in the appendix of this book.

Table III: Uniform Lifetime Table for IRA Owners

Generally speaking, most IRA owners will use Table III. In effect, the agedependent projected distribution periods in Table III are based on joint life expectancy projections of an IRA owner and a hypothetical beneficiary not more than 10 years younger. Using a joint life expectancy is advantageous because the longer joint-life expectancy factor reduces the annual RMD. But rather than using the actual life expectancy of the beneficiary for the calculations, the IRS simplifies the terms. Table III deems all beneficiaries—from children to grandmothers—to have a life expectancy 10 years longer than that of the owner. At age 71, the projected distribution period is 26.5 years (roughly the single life expectancy from Table I plus 10 years, although you must refer to the tables for the precise factor).

MINI CASE STUDY 5.1

RMD Calculation for IRA Owners

Bob turns 75 in 2015. As of December 31, 2014, he has two IRAs that are each worth $500,000. He names his son, Phillip, as the beneficiary for one IRA and his 72-year-old wife, Mary, for the other. To calculate his 2015 RMD for the IRA with his wife as beneficiary, he takes the life expectancy at his age 75 from Table III, 22.9, and divides that into his balance, $500,000, to arrive at $21,834. He uses the same table and the same factor to arrive at the same RMD from the IRA that has his son as the beneficiary. When Bob dies, the amounts that his wife and son will be required to take from the IRAs they inherited from him will be different. I’ll go into more detail about that later in this chapter.

Table II: Joint Life and Last Survivor Expectancy Table for IRA Owners with Spouses 10 or More Years Younger

Because nothing that the government does is ever without complications, there is an exception for married individuals when the IRA owner is 10 or more years older than his or her spouse. Those individuals are permitted to use their actual joint life expectancy factor, which will result in smaller RMDs.

Table 5.1

MINI CASE STUDY 5.2

RMD Calculation with IRA Owner and Spouse More Than 10 Years Younger

Bob will have to use a different calculation for the RMD for the IRA with his wife as the beneficiary if Mary is only 63 years old. According to Table II, Bob’s and Mary’s joint life expectancy factor based on their ages they will be on their birthdays in 2015 is 24.3. Bob calculates his RMD by dividing 24.3 into his balance of $500,000 to arrive at $20,576. Bob’s RMD for the account with his wife as the beneficiary is lower than for the account with his son as the beneficiary because Bob and his wife were permitted to use their actual joint life expectancy factor for his calculation.

We will cover more about IRA beneficiaries in Chapter 13. For now, please look at the table on preceding page to see how the age of his spouse affects Bob’s RMD.

Table I: Single Life Expectancy Table for IRA beneficiaries

When a spouse dies before age 70½, the younger spousal beneficiary of the IRA has two options. He or she can roll the inherited IRA into his or her own IRA, and begin RMDs when he or she reaches age 70½. Or, he or she can decline to treat the IRA as his or her own and simply defer distributions until the year that the original IRA owner would have attained age 70½. At that point, he or she would begin distributions based on his or her Table 1 life expectancy factor. This is an extremely important decision that you will have to make if your spouse predeceases you, and the advantages and disadvantages of each option are covered in detail in Chapter 13.

Nonspouse beneficiaries of inherited IRAs have no options. They must begin to take distributions based on their own life expectancy (as projected in Table I) as of the year following the year of the IRA owner’s death. For each subsequent year, the non-spouse beneficiary subtracts one (1) from his original factor, because his life expectancy is diminished by one year for every year he survives. This is frequently referred to as the “minus one method.”

Calculating Your Life Expectancy after the Initial Year

It is interesting to note that Table 1 life expectancies are reduced by one full year as each year passes. Tables II and III, however, reduce the life expectancy of the IRA owner by less than one year. This is analogous to the old double recalculation method. (Readers who remember those rules get bonus points). The idea is that as we age, our life expectancy declines, but it does not decline by an entire year.

So, if you are a surviving spouse who inherits an IRA, but you don’t treat the inherited IRA as your own IRA, your life expectancy is recalculated each year based on the life expectancies shown in Table I (the full year decline). When you die, your nonspouse heirs must use your life expectancy at the time of your death, reduced by one for each subsequent year, for their RMD calculation. For a discussion on whether a spouse should treat an IRA as his or her own IRA, refer to Chapter 13.

Timing Your First Required Distribution

Retirement plan owners born between July 1, 1944, and June 30, 1945, will have to take one distribution in 2015 and one in 2016, or two distributions in 2016 if they fail to take a distribution in 2015. If you fail to take a distribution in 2015, the first distribution in 2016 will have to be taken prior to April 1, 2016 (in effect, for what should have been taken in 2015), and the second distribution will have to be taken by December 31, 2016.

A retirement plan owner born between July 1, 1945, and June 30, 1946, will reach age 70½ during 2016.Technically, he or she could delay taking the first RMD until April 1, 2017. The rule was, and remains, that the required beginning date for taking RMDs is April 1 of the year following the year the owner turns 70½. However, if the owner was born between July 1, 1945, and June 30, 1946, and he or she waits until 2017 to take the first distribution, then that person must take two distributions in 2017. The first distribution would be due before April 1, 2017, and the second distribution would be due by December 31, 2017. Annual minimum distributions would continue for the rest of the participant’s life.

Failing to take a minimum distribution when required, or not taking a large enough minimum distribution has very expensive consequences. The IRS charges a 50 percent excise tax on the amount that was not distributed as required. So if you were required to take a $10,000 minimum distribution and didn’t do so, you will owe $5,000 in excise tax. And that’s in addition to the normal income tax you will owe on the distribution, as well as general penalties for underpayment of tax.

For participants born July 1, 1946, or afterward, there is no RMD for 2016. Unless the participant needs the money or is pursuing the early distribution of an IRA because of a lower income tax bracket or estate plan strategy, he or she is better off leaving the money in the IRA and taking the first RMD in 2017 or later.

So, if you have a choice, should you limit your distributions to one per year, or should you wait and then take two the following year? If you take a minimum distribution the year that you turn 70½ and only one distribution the following year, you may remain in a lower tax bracket, which would be advantageous. Taking two distributions in one year, though, could push you into a higher tax bracket and possibly accelerate the phase-out of certain tax credits or deductions. If that is the case, you will likely be better off violating our “Pay taxes later” rule by taking one distribution and paying some tax before you have to. On the other hand, if you will remain in the same tax bracket even with two distributions, then it makes no difference if you wait until you are required to begin distributions. This allows you to take advantage of the additional period of tax-deferred growth.

Special Rule for qualified Plan Owners Who Are Still Working Past Age 70½

RMD rules apply to traditional IRAs (not Roth IRAs) and qualified plans [401(k)s, 403(b)s, Roth 401(k)s, and Roth403(b)s, etc.). However, the rules governing 401(k)s and 403(b)s are slightly different than for IRAs.

• If you are still working after age 70½, the IRS does not require you to take a distribution from the retirement plan connected to your current job as long as you do not own more than five percent of the company. Remember, though, that your employer is responsible for setting the rules for your plan. Even though the IRS doesn’t require you to take a distribution, your employer might.
• If you have a plan such as a 401(k) associated with a job from which you have retired, the IRS says you will have to take your initial RMD by April 1 of the year following the year in which you reach age 70½. Some employers allow you to keep your retirement plan with them when you start to take withdrawals, and some employers require that you roll the account into an IRA before you start to take withdrawals.
• If you have two or more retirement plans associated with jobs from which you have retired, the IRS requires that each plan calculate a minimum distribution for you when you reach age 70½. This is different from their rules for calculating RMDs on IRAs, which allow you to add up the values of all of your IRAs, calculate the RMD, and then take the full distribution from one account. This can be a very important consideration for people whose old plans happen to include stock in the company they worked for, because the RMD requirement might cause you to have to sell stock when the value is low. As long as you have enough other assets to pay the tax on the RMD, though, you can take your company stock as an “in-kind” distribution and keep it in a brokerage account until the time that it increases in value again. The one exception to this rule is for 403(b) plan owners. The IRS allows participants in 403(b) plans to add up the values of all their accounts, calculate the RMD, and then take the full distribution from one account. For individuals such as retired university professors who have multiple 403(b) plans, this makes the paperwork much simpler to deal with at year end.
• If you had a 401(k) plan from a former job and rolled that 401(k) plan into a plan associated with the job at which you are still working, then you will have to check with the plan administrator of your current plan to see whether you will be forced to take RMDs upon attaining age 70½ from the portion of that 401(k) plan that is attributable to your former employment. PLR 200453015, published in January 2005, states that the IRS permits deferral of the RMDs on all of the funds in the new employer’s account including the rollover contributions from the former employer until April 1 of the year after the employee retires from the new employer. You must, however, make sure that your employer’s plan will allow you to do what the IRS will allow you to do.

MINI CASE STUDY 5.3

RMD if Still Working Past Age 70½

Joan continues to work although she is older than 70½. She has a total of $1 million in her 401(k) plans: $500,000 associated with her current job and $500,000 from a former job. She has never consolidated the two plans. Her new plan includes both her and her employer’s most recent contributions.

By April 1 of the year after she turns age 70½, she will be required to take minimum distributions from the $500,000 associated with the job she left, but not from the account that is still active due to her employment. Whether she could take the money from the 401(k) from the job she retired from, roll it into her current plan (by trustee-to-trustee transfer), and avoid an RMD is not clear. The IRS will allow it, but her current employer may not. If your employer does permit it, this may be an incentive for someone still working after age 70½ to consider rolling money out of their IRA and into a retirement plan at work. Usually, I prefer money going the other way, which is from 401(k) to IRA, or my current preferred strategy, from a work 401(k) or IRA to a one-person 401(k) plan that you control.

I have a client who became really excited about the prospect of avoiding his minimum distribution. He wanted to start his own retirement plan [actually a one-person 401(k)] based on his small self-employment income. Then he wanted to roll his IRA into a one-person 401(k) and suspend his RMDs on his IRA. It was a good thought, but with a fatal flaw. He is more than a five percent owner of his consulting business, and the rule about deferring the RMD after 70½ if you are still working does not apply to individuals with a five percent or greater ownership in the company.

Special Rules for 403(b) Participants

Participants in 403(b) plans are subject to some special rules that do not apply to participants in other types of plans. Both employee and employer contributions to a 403(b) plan made before January 1, 1987, are not subject to RMDs until age 75. As a result, the balance that was in your 403(b) as of December 31, 1986, is not subject to RMDs until you reach age 75, not age 70½, even if you have retired. If you fall into this special category of 403(b) account holders, you should consult with your organization’s benefits office to determine the balance in the account as of December 31, 1986. Surprisingly, many institutions, including TIAA-CREF, do a good job of tracking that balance. If your 403(b) plan included pre-1987 contributions and you roll it into an IRA, the “grandfathered” status of those contributions is lost, and you will be required to take minimum distributions on them at age 70½. Contributions made on January 1, 1987 and later are subject to RMDs at age 70½. Note, however, that the growth and appreciation on pre-1987 dollars is not grandfathered and is treated like a regular 403(b).

On the other hand, when you actually calculate the tax advantage of keeping the funds in the 403(b) to defer a portion of the minimum distribution, it is relatively small. If you think you could get even a slight investment advantage by doing a trustee-to-trustee transfer from your 403(b) to an IRA to gain additional investment options, it would still be worthwhile.

Retired public safety officers, including law enforcement and firefighters, have a special exception to the distribution rules. They can receive a distribution of up to $3,000 completely tax-free from their 403(b), as long as the proceeds are used to directly pay for accident, health or long-term care insurance.

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A Possible Compromise for Those Who Don’t Need Income and Are Charitably Inclined

Although there is no way to avoid taking RMDs from traditional (not Roth) IRAs, there is an option available to those individuals who do not need that income for living expenses, and who are inclined to donate to charity. The Pension Protection Act of 2006 created something called a Qualified Charitable Distribution, which allows IRA owners to specify that a payment of up to $100,000 from their RMDs be sent directly to a qualified charity. Here is how it works. IRA owners electing this option are still required to take their RMD, but the amount of the distribution that is sent directly to the qualified charity can be excluded from their gross income. For individuals who are charitably inclined, this can make a lot more sense than having the RMD sent to them, and then issuing a separate check to the charity, particularly if the taxpayer can’t itemize deductions. (Married couples who have incomes in excess of $309,900 in 2015 will be subject to a limitation on their total itemized deductions, including their charitable contributions). So, if you can’t itemize, the charitable contribution isn’t tax deductible, and the IRA distribution is taxable. With a Qualified Charitable Distribution (QCD), you still can’t deduct the charitable donation, but at least you’re not taxed on the IRA distribution. In addition, ther are many potential tax benefits from reducing your adjustied gross income using a QCD:

• Less of your Social Security income may become taxable
• The phase-out of medical expenses you claim as itemized deductions is reduced
• The phase-out of total itemized deductions is reduced
• The Net Investment Income tax surcharges can be reduced
• You may avoid future increases in your Medicare premiums
• Your Alternative Minimum Tax may be reduced.

QCDs were originally supposed to be effective only in 2006 and 2007, but Congress has extended them on a temporary basis every year, through 2014. Although they are not in the law for 2015 and beyond, they could very well be extended into future years. Decisions about extending QCDs have historically been done very late in the year. If you plan to wait until a definite decision has been made about QCDs before requesting your RMD, your retirement plan custodian might not have time to process your request. Since failing to take your RMD when required is a very expensive mistake, I recommend making all customary charitable donations directly from your IRA. If Congress extends the QCD provisions, you were able to take advantage. If they aren’t extended, then there is no harm done. The full amount of your IRA distribution will be treated as taxable income, which is what would have happened anyway.

Qualified Charitable Distributions have three criteria that you must be aware of:

1. You have to make sure that the charitable organization is a qualified charity. A qualified charity is one that has a valid tax-exempt status, according to the US Treasury. There are some very good causes that I personally donate to, but they do not meet the definition of a qualified charity. As such, I cannot deduct those contributions nor could I send them a QCD. The organization will be able to tell you if they’re tax-exempt or not, or, if you want to be 100 percent sure, you can ask the IRS.

2. You have to be at least 70½ to make a QCD.

3. QCDs are only available for IRAs, or inactive SEPs and SIMPLE plans. QCDs from an employer-sponsored retirement plan are currently not permitted.

If you don’t need the cash,
I recommend scheduling
your distribution for
Thanksgiving or early
December.

When Should You Schedule Taking Your RMD?

Theoretically, you should take your RMD on December 31 to delay as long as possible withdrawing money from the tax-favored environment. In the real world, however, it is difficult to get any work done with financial firms in December, and trying to comply with a deadline between Christmas and the last day of the year is a total nightmare. Remember, if you miss taking a withdrawal by year-end, you face the 50 percent penalty for failing to take your RMD—an expensive penalty. If you don’t need the cash, I recommend scheduling your distribution for Thanksgiving or early December. If you need the RMD for your spending needs, it may be best to schedule 12 equal monthly distributions throughout the year.

How to Get Your Interest-Free Loan from the IRS

I do not understand why anyone would have extra tax taken out of their paycheck to ensure that they get a big refund. Why on earth would you give the IRS an interest-free loan? It should be the other way around! Would you like to get an interest-free loan from the IRS? One way to do so is to take your RMD in December and have federal income tax withheld from it, rather than paying quarterly estimated taxes on your retirement income throughout the year. From the IRS’s perspective, tax that is withheld is treated as if it has been withheld at an even rate throughout the year as opposed to being treated like a single estimated tax payment you made late in the year – so you won’t get penalized for paying all of the tax due in December. Here’s an even better idea for those of you who hate paying estimated taxes and who love being “floated” by the IRS. If you are currently paying quarterly estimated taxes on your non-IRA income, you can forgo your estimates completely and instead ask your IRA custodian to do up to a 100 percent tax withholding on the RMD you take at the end of the year. Let’s say that you have been paying estimates of $1,500 each quarter, and you’ve been told that you will have to take a RMD of $6,000 this year. In December, you can instruct your IRA custodian to withhold federal income tax from your RMD at a rate of 100 percent, and have them send the entire $6,000 directly to the IRS. This strategy allows you to earn interest on the money you are required to take from your IRA for as long as possible, and also allows you to earn the interest on the estimated tax payments that you were going to send to the IRS. The best part is that, under current rules, as long as the amount of taxes withheld from your RMD is sufficient to cover the amount of tax you owe for the entire year, there is no penalty for paying 100 percent of your tax liability in December!

A Key Lesson from This Chapter

Keep your RMD to the required minimum. Do not take out more money than you need so that you keep the balance in your tax-deferred accounts as large as possible.