1) What are required minimum distributions (RMDs)?
Required minimum distributions, often referred to as RMDs, are amounts that the government requires you to withdraw annually from IRAs and employer-sponsored retirement plans after you reach age 70½. You can always withdraw more than the minimum amount from your IRA or plan in any year, but if you withdraw less than the required minimum, you will be subject to a federal penalty.
The RMD rules are designed to spread out the distribution of your entire interest in a retirement account over your lifetime. The purpose of the RMD rules is to ensure that people don’t just accumulate retirement accounts, defer taxation, and leave these funds as an inheritance. Instead, required minimum distributions generally have the effect of producing taxable income during your lifetime.
2) Which retirement savings vehicles are subject to the RMD rules?
In addition to traditional IRAs, simplified employee pension (SEP) IRAs and SIMPLE IRAs are subject to the RMD rules. Roth IRAs, however, are not subject to these rules. If you own more than 5% of the company sponsoring a retirement plan, you must also take a minimum distribution from your plan. However, if you’re an employee of that company, you generally do not have to take a RMD from your plan.
If you are uncertain whether the RMD rules apply to your employer-sponsored plan, you should consult your plan administrator.
3) When must RMDs be taken?
Your first required distribution is for the year you reach age 70½. However, you have some flexibility as to when you actually have to take this first-year distribution. You can take it during the year you reach age 70½, or you can delay it until April 1 of the following year.
Since this first distribution generally must be taken no later than April 1 following the year you reach age 70½, this April 1 date is known as your required beginning date. Required distributions for subsequent years must be taken no later than December 31 of each calendar year. This means that if you opt to delay your first distribution until April 1 of the following year, you will be required to take two distributions during that year–your first year’s required distribution and your second year’s required distribution.
4) How are RMDs calculated?
For most taxpayers, calculating RMDs is straightforward. Since it’s partially based on whom you’ve designated as your beneficiary, it’s important to review your beneficiaries ahead of time. Most brokers or custodians will calculate your RMD for you. For each calendar year, your RMD is calculated by dividing your account balance as of December 31 of the prior year by your distribution period, determined under the Uniform Lifetime Table using your attained age in that calendar year. This life expectancy table is based on the assumption that you have designated a beneficiary who is exactly 10 years younger than you are. Every IRA owner’s and plan participant’s calculation is based on the same assumption.
If your sole designated beneficiary is your spouse, and he or she is more than 10 years younger than you, the calculation of your RMDs may be based on the longer joint and survivor life expectancy of you and your spouse. (These life expectancy factors can be found in IRS Publication 590.)
5) What if you fail to take RMDs as required?
You can always withdraw more than you are required to from your IRAs and retirement plans. However, if you fail to take at least the RMD for any year (or if you take it too late), you will be subject to a federal penalty. The penalty is a 50 percent excise tax on the amount by which the RMD exceeds the distributions actually made to you during the taxable year.
For example: You own one traditional IRA and compute your RMD for year one to be $7,000. You take only $2,000 as a year-one distribution from the IRA by the date required. Since you are required to take at least $7,000 as a distribution but have only taken $2,000, your RMD exceeds the amount of your actual distribution by $5,000 ($7,000 minus $2,000). You are therefore subject to an excise tax of $2,500 (50 percent of $5,000). So, it’s important to make arrangements with your custodian as soon as possible to ensure your RMD is processed in a timely manner.
Bonus: What if I don’t need my RMD?
If you’re fortunate enough not to need your RMD for living expenses, consider making a qualified charitable distribution (“QCDs”) from your IRA directly to a qualified charity. A QCD will satisfy the RMD requirement. Unlike conventional RMDs, your QCD will not be subject to ordinary federal income taxes. Be aware that you can’t also claim the QCD as a charitable tax deduction—the amount is simply excluded from your taxable income. You may donate up to $100,000 and you must use the check-writing privileges on your account so that your transfer is made directly from your IRA to the charity.
You may also consider using your RMD to diversify your investments between taxable and nontaxable accounts. By transferring your RMD into a taxable account, it can potentially earn more returns for you than sitting in your checking account. Keep in mind that even after retiring, you still need to have your investments generate returns for you. Talk to your Azzad financial adviser about how to invest your RMD in a taxable account.
The information provided here is intended to be general and educational in nature and shouldn’t be construed as a substitute for legal or tax advice. Please consult an independent legal and/or tax advisor for specific advice about your individual situation.