When the Individual Retirement Account was established in 1974, it was set up to be funded solely by pre-tax dollars, giving you the benefit of reducing your taxable income and letting your capital grow tax deferred, but with it came the required minimum distribution.
The purpose of the RMD is to ensure that IRAs couldn’t grow tax deferred indefinitely and the government could secure its portion of the tax revenue it allowed you to defer within your lifetime.
Fun fact: The 401(k) started in 1978, and the Roth IRA was established next in 1997, with the latter allowing folks to pay their taxes the day they make their IRA contributions, thus allowing those contributions and gains to be withdrawn tax free. As a result, Roth IRAs aren’t subject to required distributions, since the government already received its taxes.
In 2020, the Setting Every Community Up for Retirement Enhancement Act was passed, changing the RMD age from 70.5 to age 72. The old rule stated you needed to take your RMD prior to April 1 of the following year in which you turned 70.5. Now it’s April 1 the year after you turn 72.
Following the first year, the RMD is required to be withdrawn from your IRA prior to year-end or you may be hit with a 50% penalty assessed on the amount of RMD you should have taken. Yikes!
I want to dig into some of the key “ins and outs” to know around the RMD.
Pre-tax IRAs, Simplified Employee Pension IRAs, Savings Incentive Match Plan for Employees IRAs, and many pre-tax defined contribution plans, such as the 401(k), the 403(b), and the 457(b) are subject to RMDs. Almost all qualified accounts are subject to the RMD rules. The government allowed for the benefit of growth on tax deferred accounts to help with one’s retirement but wants to ensure it sees the tax revenue at some point, even if the money is inherited.
The RMD is calculated based off the Dec. 31 value of the account and then divided by a determined life expectancy factor table. We should also note the RMD is calculated off all qualified accounts you have but taken in any combination from them. So, if you have $1 million in an IRA and $500,000 in a SEP IRA, your ending year value will be $1.5 million divided by your table rated life expectancy to reach the minimum dollar amount you need to take. You can always take more than this if your plan allows.
In 1997, it all changed with the advent of the Roth. Roth IRAs and any Roth portion of a defined contribution plan aren’t subject to RMDs while the individual who owns the account is alive. If there is a balance in the account following the passing of said individual, the beneficiary is required to take the money out of the account within 10 years. The same timeframe rules apply to the pre-tax IRA except any nonspousal beneficiary will pay ordinary income tax versus getting the distributions tax free like the Roth.
This assumes the Roth existed for five years prior to death.
Some defined contribution plans allow for one to avoid taking RMDs off their account if they’re still employed and don’t own 5% or more of the company.
If you are age 72 and would be traditionally subject to take RMDs out of your 401(k) but you are still working and deferring with the employer of the 401(k) in question, you may not have to pull money out. We’ve been able to help folks avoid unnecessary tax on by maximizing their 401(k) contribution through salary deferral—if they’re not doing so already—and using their RMD from other qualified accounts to live off in lieu of their income.
That way, they aren’t subject to paying tax on their earned income and their RMD. This method could keep them from jumping into the next marginal tax rate.
An additional strategy is to work with your CPA to determine the amount you can convert from your pre-tax accounts to your post-tax accounts on an annual basis without bumping up into the next tax bracket. While this method might not make sense for high-income earners, it will help others lessen minimum distributions when the time comes and give the benefit of tax-free growth.
Ben Klundt is a financial adviser at Ten Capital Wealth Advisors LLC, in Spokane. He can be reached at 509.325.2003 and
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