RMDs: How to Calculate and Make the Most of Them

It is currently happening to some and eventually, it will likely happen to all of us. I am referring to required minimum distributions (RMD). The RMD is the amount the Internal Revenue Service requires you to withdraw each year from your IRA, SEP IRA, SIMPLE IRA or retirement plan account when you reach age 70.5.

Even though there is a calculation (see below) that will help you determine how much you must withdraw from your retirement account, your withdrawal can be more than the mandatory minimum amount.

Once withdrawn, the RMD will be included in your taxable income, which depending on the amount of income that you are receiving in retirement, could kick you into a higher tax bracket. Ouch! This feels even more painful if you consider that many people who are required to take annual RMD would rather just leave the funds in their retirement account because they don’t need the extra income. 

When to Calculate the Required Minimum Distribution

The first thing you must know is that according to IRS.gov, “The required minimum distribution for any year is the account balance as of the end of the immediately preceding calendar year divided by a distribution period from the IRS’s ‘Uniform Lifetime Table.’ A separate table is used if the sole beneficiary is the owner’s spouse who is 10 or more years younger than the owner.” (For related reading, see: Understanding Required Minimum Distributions.)

If you own multiple IRA accounts, you can withdraw the RMD from any one of your IRA accounts, based on the total value of your IRA(s).

What Is the Beginning Date for Your Required Minimum Distribution?

  • For IRAs, including SIMPLE IRAs and SEP IRAs: April 1 of the year following the calendar year when you reach age 70.5.
  • For 401(k)s, profit-sharing, 403(b)s, or similar defined contribution plans: usually April 1 following the calendar year you become age 70.5 or retire, whichever happens last.

What Happens Once You Turn 70.5?

  • You retired, and your 70th birthday was June 30, 2013. You became 70.5 on December 30, 2013. Therefore, your RMDs for 2013 will be due by April 1, 2014.
  • You retired, and your 70th birthday was August 1, 2014. You became 70.5 on February 1, 2015. Although you will not have to take RMD for 2014, you will have to withdraw RMD by April 1, 2016, based on the amount actually withdrawn in 2014.

Here is the calculation if your spouse is the sole beneficiary of your IRA and he or she is more than 10 years younger than you:

1.    IRA balance on December 31 of the previous year: _________________

2.    Your age on your birthday this year: _____________

3.    Your spouse’s age on his or her birthday this year: _____________

4.    Life expectancy from IRS Life Expectancy Table II at the intersection of your and your spouse’s ages: _______________

5.    Divide line 1 by the number entered on line 4. This is your required minimum distribution from this year from the IRA: ____________

6.    Repeat steps 1 through 5 for each of your IRAs

The Consequences for Failing to Withdraw Your RMD

Whatever you do, do not make the mistake of not withdrawingwithdrawing your RMD by the due date. If you do, the IRS will gladly hit you with a 50% excise tax on the amount you were supposed to withdraw. Double ouch! By the way, if you are the non-spouse beneficiary of someone else’s IRA and they die, then you are required to take RMDs by December 31 in the year after the original IRA account holder died. For example, if the original IRA account holder died on January 1, 2016, then the non-spouse beneficiary must begin taking RMDs by December 31, 2017. (For related reading, see: Distribution Rules for Inherited Retirement Plan Assets.)

How You Can Convert Your RMDs Into Tax-Free Income

When someone takes their RMD, in many cases they do not have an immediate need for those funds. Therefore, one solution to beat the IRS at its own game is by using the unwanted required minimum distributions to purchase life insurance with cash value, such as an indexed universal life (IUL) policy. IUL is a cash-value-based life insurance policy where a portion of the insurance premium (in this case whatever amount of your unwanted RMDs you decide to allocate to an IUL) payments are deposited into a fixed account (in some instances this account is an interest-bearing account) or an account that is pegged to a particular index, such as the Dow Jones, S&P 500, or a bond index.

As the cash value account grows tax-deferred, you will have the opportunity to take withdrawals on a tax-free basis. Be advised that cash value policies such as an IUL have surrender charges that will reduce the value of your cash value account by a percentage that can be as high as 10%. Usually, the surrender charge is higher in the early years of owning a cash value policy and it gradually declines year over year by 1% to 2% until the policy becomes surrender free. (For related reading, see: 5 Tax Advantages of Indexed Universal Life.)

The cash value has the opportunity to compound with positive performance of the underlying index. When withdrawals are taken they are considered policy loans. In other words, the insured may borrow funds from the policy without having to pay taxes on the withdrawal. Now, before you get all excited and decide to sock away a small fortune in an IUL policy, you should first speak with a licensed insurance agent because you need to understand the impact of over-funding a life insurance policy for the sole benefit of building up the cash value in anticipation of taking tax-free withdrawals.

(For more from this author, see: How to Build Excellent Credit and Improve Your Credit Score.)