How to avoid a 50% penalty tax on your Required Minimum Distribution – Part 1

Rob married his high school sweetheart Gina just after he safely returned from the Vietnam War. Together they raised a family and built a successful furniture business. Gina, born on June 30, is nine days older than Rob, born July 8, so they split the difference and celebrate their birthdays together, every year on Independence Day.

Since the 70’s, they have rarely missed an opportunity to take a tax deduction for their IRA contributions. As in so many other aspects of their lives, they invested the same amounts and in the same way. Today they have virtually identical $500,000 IRA accounts, from which they each take $1,000 per month to supplement their investment and social security incomes.

Now for the first time in over five decades, they have a birthday they cannot celebrate together. They both turn 70, but only Gina turns 70½ this year. Rob does not hit this significant milestone until next year, on January 8.

Why is that important?

Because age 70½ triggers the Required Minimum Distribution (RMD), the year that the Internal Revenue Service makes IRA owners take at least the RMD amount from their IRA accountsi. So, Gina is subject to the RMD this year, while it does not apply to Rob until next.

Let’s break down the RMD into its very descriptive three words.

First, it is required. Any amounts failing to satisfy the RMD are penalized with a whopping 50% excise tax.

It is a minimum amount, determined by the account value on December 31 and the attained age of the owner. Rob and Gina are both taking 2.4% ($1,000 / month or $12,000 per year from $500,000 accounts is 2.4%), but that is not enough to satisfy the RMD.

Finally, it is a distribution. It is an amount that must be taken as income, subject to income tax, and cannot be rolled into another IRA type account.ii

This year, Gina’s RMD amount is 3.65% or $18,250 of $500,000. That is about $520 more per month than she currently withdraws, but they can adjust their combined distributions to delay for one more year taking more than the $24,000 total they need. Rob reduces his by the amount Gina increases hers to satisfy the RMD.

However, next year, Rob is also subject to the RMD, and because they will both reach age 71, they must take 3.77% of their December 31 balances. That works out to $18,850 of $500,000iii each, $37,700 total, $1,142 more per month than they need. The RMD percentage grows every year, exceeding 4% when turning 73, passing 5% when reaching 79 and is more than 6% at age 83.

Rob and Gina do not plan to spend the additional income they are forced to take by the RMD each year. Instead, they are using the extra income to fund the Section 529 College Savings plans for their grandkids.

Contact us for advice on satisfying the RMD from your retirement plans. While we believe the calculation relatively straightforward, there are enough nuances, especially on the first year’s distribution, that we encourage everyone to give us a call to help get it right.

In part two we look at how the RMD applies to the kid’s accounts when they inherit IRA assets.

Click here to read part two.

 

i The same rules, but with several exceptions to the details, apply to qualified plans, like 401k and 403b plans. Unlike IRAs, qualified plans allow postponement of the RMD if the owner continues working and contributing past 70½.

ii If a person owns multiple retirement accounts subject to the RMD (Roth accounts never require minimum distributions), the total RMD covering all accounts can be satisfied with distributions from any of the accounts.

iii For simplification of the math, we’ll assume the account balances don’t change. In the real world, values are likely to change according to investment returns, as well as the distributions taken from the account.

TRACKING #1-612290