Required minimum distributions (RMDs) are mandatory minimum annual withdrawals from a traditional IRA, simplified employee pension plan or a simple IRA that typically must start when the account holder turns 70½. Failure to do so results in penalties. In fact, penalties for failure to take less than the required RMD can be as much as 50% of the amount not taken.
For Roth IRAs, however, the original owner is not subject to RMDs because Roth contributions are made with after-tax funds and are generally not subjected to the same rules and regulations as traditional IRAs. (For more, see: Avoiding Mistakes in Required Minimum Distributions.)
You typically have until April 1 of the year following the calendar year when you turn 70½ to take your first RMD. After that, the deadline is December 31. If you hold multiple retirement accounts, experts recommend creating a plan that takes into consideration all of your retirement income sources and any required withdrawals which must be taken. Some qualified IRAs permit certain account holders to defer commencing their RMDs until retirement even if they are past age 70½. Consulting with an experienced financial planner will help you navigate the specific rules and regulations.
Determining the Amount
Basically, the RMD is calculated by dividing the adjusted market value of the account by an applicable life expectancy factor. To simplify this complicated process, the American Academy of Actuaries has released an online tool to help consumers determine their life expectancy factor and the U.S. Social Security Administration has an easy to use life expectancy calculator as well. While you must withdraw the RMD, you may also withdraw any amount above that figure up to the full value of the account.
How RMDs Are Taxed
RMDs are taxed as regular income for the tax year in which they are withdrawn and at the individual’s applicable federal income tax rate. They may also be taxed at both the state and local level depending on the account holder’s residence. If, however, you designate your RMD as a qualified charitable distribution (QCD) and the funds are directly transferred to a qualified charity, then this amount may be exempt from being taxed. (For related reading, see: Top Tips to Reduce Required Minimum Distributions.)
Generally, there are three types of inherited IRA relationships: spouses, non-spouses or entities (like a trust or estate.) Spouses have the added benefit of rolling over an inherited IRA into their own account or transferring the funds into an Inherited IRA. Thus, if you inherited an IRA from your spouse and rolled it over into your own IRA, RMDs are required based on your age. Therefore, if you haven’t yet reached age 70½, then you can delay distributions until you reach that age.
When an IRA is inherited by someone other than a surviving spouse, the IRA becomes a beneficiary IRA or inherited IRA. Consequently, different rules governing RMDs apply. Generally, the IRS requires these beneficiaries to commence taking RMDs from the inherited IRA starting December 31 the year following the year of death of the original owner. The first year RMD is calculated based on the beneficiary’s age and each subsequent year’s RMDs are calculated by subtracting one year from the initial life expectancy factor.
In most cases, if you inherit an IRA, you must take required annual RMDs. Failure to do so will result in a 50% IRS penalty assessed to the RMD. (For more, see: How to Use the QCD Rule to Reduce Your Taxes.)