Advisors: Clients Must Take First RMD by April 1

Tax season has begun and the April 18 deadline to file returns is top of mind for most. However, for those faced with taking their first required minimum distribution (RMD) from an IRA or other retirement account, April 1 is a key deadline not to be missed. Any RMD not taken by the required date is subject to a 50% penalty plus the taxes that would otherwise be due.

This issue is especially pertinent for Baby Boomers, as this year the oldest among that generation's 75 million members must start taking their RMDs, whether they need the income or not. Retirees with 401(k) plans or certain IRA accounts are required to begin taking distributions when they reach age 70½, if they haven't already begun. The impact of these impending withdrawals from Baby Boomer retirement accounts is expected to spread across the market, since this generation has about $10 trillion set aside in these kinds of tax-deferred accounts. While the IRS may be eager to finally begin taxing those savings, money managers of all sizes have been relying on those assets for at least a portion of their income.

Many financial advisors have clients who are either taking RMDs or will need to do so soon, and there are many ways they can help, from ensuring clients don’t miss the deadlines to avoiding double taxation. (For related reading, see: 8 Retirement Income Strategies for Boomers in 2017.)  

Boomers in that age group who don't have a financial advisor might consider talking to one. At the very least, read the following to avoid being caught by the penalty.

How RMDs Work

For those who are 70½ or older, taking an annual RMD from IRAs and other retirement accounts is mandatory. The amount of the distribution is calculated off of the account(s) balance at the end of the prior year and is based upon an IRS table. The distribution must be normally be taken by end of the current year and is subject to federal and state income taxes. Custodians are obligated to report the amount of the RMD to the IRS and also the amount actually taken. If there is a shortfall this will trigger the 50% penalty. (For more, see: How to Calculate Required Minimum Distributions.)

First Year RMDs

The rules are a bit different for those who are taking their first RMD. The calculation of the first year RMD is the same – the value of the appropriate account(s) at the end of the prior year with the applicable factor from the IRS table. The difference is that for the first year’s RMD only you have the option of deferring that distribution until April 1 of the calendar year following the year you turned 70½. For example, let’s say your client turned 70½ on January 2 of 2015. In this example their RMD for 2015 calculates as $20,000 based on their age and the amount in their IRA account as of December 31, 2014. They have the option to defer all or part of this initial RMD only until April 1, 2016.

A Double Tax Hit

Waiting until April 1 of the following year to take their initial RMD can pose the problem of a double tax hit in that second year. Waiting until the following April subjects the client to paying taxes on two distributions in that following year. In our example above, let’s say the client’s $20,000 distribution for 2015 is followed by a $21,000 distribution for 2016 based upon their year-end 2015 account balance and the factor from the IRS table. This means that they will need to take $41,000 in distributions, if they delay the first year RMD, by the end of 2016 and pay the applicable taxes. (For more, see: Avoiding Mistakes in Required Minimum Distributions.)

Depending upon your client’s tax situation this extra income could push them into a higher tax bracket for 2016. It could also impact the amount of tax that might be due on their Social Security benefits and impact their Medicare costs for next year.

Retirement Planning Opportunities

While it might generally be a good idea to take the first year’s RMD in the year it pertains to in order to avoid the double hit in the next year, this might not always be the case. As with all things in financial planning, the answer will depend upon the client’s unique situation.

For example, if the client will have unusually high income in the year in which they turn 70½ it may prove advantageous for them to defer the distribution until the following year even if they have to take two distributions that year. Another opportunity for your client is the qualified charitable distribution or QDC. If they are charitably inclined and don’t need some or all of the money from the distribution, then this is a great way for them to donate to a charity and reduce the tax hit on the RMD. The QDC is a great tool for any year for clients taking their RMD. But if for whatever reason they have elected to defer their first year RMD until the following year, the QDC provides a great way to reduce some or all of their tax liability in the year the two distributions are required. (For more, see: Top Tips to Reduce Required Minimum Distributions.)

For clients wishing to reduce their RMDs in general, some planning before reaching age 70½ can serve to reduce the amount of the initial and subsequent RMDs. One tool in particular is converting traditional IRA assets to a Roth IRA. This reduces the amount of the RMDs and can serve as an excellent IRA estate planning vehicle. If it works for your client’s situation this can be a great strategy.

The Bottom Line

Clients can defer taking their first RMD until April 1 of the calendar year following the year in which they turn 70½. If your client has done this, it is crucial that you ensure the distribution is taken by April 1 of that year in order to satisfy their RMD requirement and avoid the substantial 50% penalty that applies to any amount not taken. There are planning opportunities surrounding the timing of this first RMD, but the most crucial aspect is meeting this deadline. (For more, see: How Much Should Retirees Withdraw from Accounts?)