What Baby Boomers Need to Know About IRA RMDs
This year marks the beginning of a new era for the Baby Boomer generation. The oldest of its members who were born in the first half of 1946 will reach the age of 70 ½ in 2016. This means that they will have to start taking required minimum distributions (RMDs) from all of their traditional IRAs and qualified plans per Internal Revenue Service (IRS) regulations, regardless of whether they want or need this money. Here are some essential tips about these distributions that can help Boomers to effectively integrate them into their budgets.
- The IRS rule states that traditional IRA and qualified plan owners can delay their RMDs until the year after the year in which they turn 70 ½. Those born in the first half of 2016 will turn 70 ½ this year, while those born in the latter half will reach that age the following year. This means that you have to start your RMDs in 2016 by December 31st if your birthday falls between January 1 and June 30th. If you were born in the second half of 1946, then you can delay your RMDs until April 1 of 2018, because you will turn 70 ½ in 2017, so you won’t have to take RMDs until the following April. However, you will have to take two distributions at that time to make up for the delay in taking your first one. (For more, see: How to Calculate Required Minimum Distributions.)
- You don’t have to take RMDs from every single IRA and qualified plan balance that you own. You can do this if you like, but it may be simpler to aggregate all of your plan distributions and take them from a single account. This can be especially beneficial if you have holdings in other accounts that are trading at depressed prices, and you don’t want to have to start selling them in order to take distributions. Calculating the amount that you need to take is not as hard as you may think. You just need to get the ending account balance for each traditional plan and account on December 31st of last year and add them all together. Then find your life expectancy factor in the IRS tables (see IRS publications 590 and 575) and divide your total balance by this number. The quotient is the dollar amount that you will have to take out this (or next) year. If your spouse is more than 10 years younger than you and is the sole beneficiary of your traditional plans and accounts, then you will need to use an alternate set of tables supplied by the IRS that will divide out to a larger number.
- You cannot aggregate distributions from 401(k) plans. If you have more than one traditional qualified plan lying around that you must take RMDs from, you will have to calculate and take them individually. But you can still aggregate your IRA distributions and take them from one account. If you don’t want to have to take separate distributions from your plans going forward, then you can simply roll them into an IRA to avoid this inconvenience. (For more, see: An Overview of Retirement Plan RMDs.)
- Find out how this income will impact your tax situation. All distributions from traditional IRAs and retirement plans are taxed as ordinary income, which means that you will pay on this money at your top marginal tax rate. RMDs may also make your Social Security benefits taxable depending upon how much you must withdraw. However, just because this income is taxable does not automatically mean that you will pay tax on it. If you are currently eligible to claim deductions and/or credits that go unused because you don’t have income to credit them against, then you can use them to pay for some or all of the tax on your distributions.
- If you have ever made nondeductible contributions to your traditional IRA, then you will have to compute the total amount that wasn’t deducted and then add them to the total amount of deductible contributions. Then divide the total by the amount of nondeductible contributions to get an exclusion ratio. This percentage of each of your distributions will then be considered a nontaxable return of principal. For example, if you did not deduct $10,000 of your contributions and did deduct $90,000, then 10% of each distribution will be tax-free. You should have kept track of your nondeductible contributions by completing IRS Form 8606 in each year that you made them. (For more, see: Avoiding Mistakes in Required Minimum Distributions.)
- Don’t even think about simply skipping your RMDs. The IRS will eventually levy a penalty on you that is equal to a whopping 50% of the amount that you should have withdrawn, so this is never a good idea.
- You can completely and legitimately avoid having to take RMDs by rolling or converting all of your traditional plans to a Roth IRA. Although it may be best to spread the conversion out over two or more years in order to prevent yourself from going into a higher tax bracket, you will never have to take any further distributions from any of your retirement funds again. Roth IRAs are unconditionally exempt from the RMD provision. Even Roth qualified plans do not have this exemption. If you have any balances in these and wish to escape RMDs for them, then you will also have to roll them into Roth IRAs. (For more, see: Top Tips to Reduce Required Minimum Distributions.)
- If you are inclined to make charitable donations, you can arrange to have your RMDs funneled directly to a qualified 501c(3) organization. This will effectively make your distributions tax free, as you never received the money yourself. This strategy essentially allows you to deduct this income without having to itemize.
The Bottom Line
Mandatory minimum distributions from traditional IRAs and qualified plans cannot be avoided, but there are several ways to minimize their impact as long as you follow the rules. Talk to your IRA custodians to see how much you will have to withdraw and begin making plans now for how you will use this money. (For more, see: A Required Minimum Distribution Reminder.)