Understanding Required Minimum Distributions & Advanced Tax Strategies For RMD’s
A required minimum distribution (RMD) is the amount that the IRS requires you to take out of your retirement account each year when you hit a certain age or when you inherit a retirement account from someone else. It’s important to plan tax-wise for these distributions because they can substantially increase your tax liability in a given year; consequentially, not distributing the correct amount from your retirement accounts will invite huge tax penalties from the IRS. Luckily, there are advanced tax strategies that can be implemented to help reduce the tax impact of these distributions, as well as special situations that exempt you from having to take an RMD.
LAW CHANGE: There were changes to the RMD age when the SECURE Act was passed into law on December 19, 2019. Prior to the law change, you were required to start taking RMD’s in the calendar year that you turned age 70 1/2. For anyone turning age 70 1/2 after December 31, 2019, their RMD start age is now delayed to age 72.
The most common form of required minimum distribution is age 72. In the calendar year that you turn 72, you are required to take your first distribution from your pretax retirement accounts.
The IRS has a special table called the “Uniform Lifetime Table”. There is one column for your age and another column titled “distribution period”. The way the table works is you find your age and then identify what your distribution period is. Below is the calculation step by step:
1) Determine your December 31 balance in your pre-tax retirement accounts for the previous year end
2) Find the distribution period on the IRS uniform lifetime table
3) Take your 12/31 balance and divide that by the distribution period
4) The previous step will result in the amount that you are required to take out of your retirement account by 12/31 of that year
Example: If you turn age 72 in March of 2023, you would be required to take your first RMD in that calednar year unless you elect the April 1st delay in the first year. After you find your age on the IRS uniform lifetime table, next to it you will see a distribution period of 25.6. The balance in your traditional IRA account on December 31, 2018 was $400,000, so your RMD would be calculated as follows:
$400,000 / 25.6 = $15,625
Your required minimum distribution amount for the 2023 tax year is $15,625. The first RMD will represent about 3.9% of the account balance, and that percentage will increase by a small amount each year.
There are very important dates that you need to be aware of once you reach age 72. In most years, you have to make your required minimum distribution prior to December 31 of that tax year.
However, there is an exception for the year that you turn age 72. In the year that you turn 72, you have the option of taking your first RMD either prior to December 31 or April 1 of the following year. The April 1 exception only applies to the year that you turn 72. Every year after that first year, you are required to take your distribution by December 31st.
Delay to April 1st
So why would someone want to delay their first required minimum distribution to April 1? Since the distribution results in additional taxable income, it’s about determining which tax year is more favorable to realize the additional income.
For example, you may have worked for part of the year that you turned age 72 so you’re showing earned income for the year. If you take the distribution from your IRA prior to 12/31 that represents more income that you have to pay tax on which is stacked up on top of your earned income. It may be better from a tax standpoint to take the distribution in the following January because the amount distributed from your retirement account will be taxed in a year when you have less income.
Very important rule:
If you decide to delay your first required minimum distribution past 12/31, you will be required to take two RMD‘s in that following year.
Example: I retire from my company in September 2023 and I also turned 72 that same year. If I elect to take my first RMD on February 1, 2024, prior to the April 1 deadline, I will then be required to take a second distribution from my IRA prior to December 31, 2024.
If you are already retired in the year that you turn age 72 and your income level is going to be relatively the same between the current year and the following year, it often makes sense to take your first RMD prior to December 31st, so are not required to take two RMD‘s the following year which can subject those distributions to a higher tax rate and create other negative tax events.
If you fail to distribute the required amount by the given deadline, the IRS will be kind enough to assess a 50% penalty on the amount that you should have taken for your required minimum distribution. If you were required to take a $14,000 distribution and you failed to do so by the applicable deadline, the IRS will hit you with a $7,000 penalty.
If you make the distribution, but the amount is not sufficient enough to meet the required minimum distribution amount, they will assess the 50% penalty on the shortfall instead.
Bottom line, don’t miss the deadline.
Exceptions If You Are Still Working
There is an exception to the 72 RMD rule. If your only retirement asset is an employer sponsored retirement plan, such as a 401(k), 403(b), or 457, as long as you are still working for that employer, you are not required to take an RMD from that retirement account until after you have terminated from employment regardless of your age.
Example: You are age 73 and your only retirement asset is a 401(k) account with your current employer with a $100,000 balance, you will not be required to take an RMD from your 401(k) account in that year even though you are over the age of 72.
In the year that you terminate employment, however, you will be required to take an RMD for that year. For this reason, be very careful if you’re working over the age of 72 and leave employment in late December. Your retirement plan provider will have a very narrow window of time to process your required minimum distribution prior to the December 31st deadline.
This employer sponsored retirement plan exception only applies to balances in your current employer’s retirement plan. You do not receive this exception for retirement plan balances with previous employers.
If you have retirement account such as IRA’s or other retirement plan outside of your current employer’s plan, you will still be required to take RMD’s from those accounts, even though you are still working.
Advanced Tax Strategies
There are two advanced tax strategies that we use when individuals are age 72 and still working for a company that sponsors are qualified retirement plan.
It’s not uncommon for employees to have a retirement plans with their current employer, a rollover IRA, and some miscellaneous balance in retirement plans from former employers. Since you only have the exception to the RMD within your current employers plan, and most 401(k), 403(b), and 457 plans accept rollovers from IRAs and other qualified plans, it may be advantageous to complete rollovers of all those retirement accounts into your current employer’s plan so you can completely avoid the RMD requirement.
Strategy number two. If you are still working and you have access to an employer sponsored plan, you are usually able to make employee contributions pre-tax to the plan. If you are required to take a distribution from your IRA which results in taxable income, as long as you are not already maxing out your employee deferrals in your current employer’s plan, you can instruct payroll to increase your contributions to the plan to reduce your earned income by the amount of the required minimum distribution coming from your other retirement accounts.
Example: You are age 72 and working part time for an employer that gives you access to a 401(k) plan. Your 401(k) has a balance of $20,000 with that employer, but you also have a Rollover IRA with a balance of $200,000. In this case, you would not be required to take an RMD from your 401(k) balance, but you would be required to take an RMD from your IRA which would total approximately $7,500. Since the $7,500 will represent additional income to you in that tax year, you could turn around and instruct the payroll company to take 100% of your paychecks and put it pre-tax into your 401(k) account until you reach $7,500 which would wipe out the tax liability from the distribution that occurred from the IRA.
Or, if you have a spouse that still working and they have access to a qualified retirement plan, the same strategy can be implemented. Additionally, if you file a joint tax return, it doesn’t matter whose retirement plan it goes into because it’s all pre-tax at the end of the day.
5% or More Owner
Unfortunately, I have some bad news for business owners. If you are a 5% or more owner of the company, it does not matter whether or not you are still working for the company, you are required to take an RMD from the company’s employer sponsored retirement plan regardless. The IRS is well aware that the owner of the business could decide to work for two hours a week just to avoid required minimum distributions. Sorry entrepreneurs.
A Spouse That Is More Than 10 Years Younger
I mentioned above that the IRS has a uniform lifetime table for calculating the RMD amount. If your spouse is more than 10 years younger than you are, there is a special RMD table that you will need to use called the “joint life table” with a completely different set of distribution periods, so make sure you’re using the correct table when calculating the RMD amount.
There is also an advanced tax strategy that allows you to make contributions to charity directly from your IRA and you do not have to pay tax on those disbursements. The special charitable distributions from IRA’s are only allowed for individuals that are age 72 or older. If you regularly make contributions to a charity, church, or not for profit, or if you do not need the income from the RMD, this may be a great strategy to shelter what otherwise would have been more taxable income. There are a lot of special rules surrounding how these charitable contributions work. For more information on this strategy see the following article:
You are not required to take RMD‘s from Roth IRA accounts at age 72, this is one of the biggest tax advantages of Roth IRAs.
When you inherit an IRA from someone else, those IRAs have their own set of required minimum distribution rules which vary from the rules at the age 72. The SECURE Act that was passed in 2019 split non-spouse beneficiaries of IRA into two categories. For individuals that inherited retirement accounts prior to December 31, 2019, they are still able to stretch the RMD over their lifetime and the required minimum distributions must begin by December 31st of the year following the decedent date of death. For individuals that inherited a retirement account after December 31, 2019, the New 10 Rule replaced the stretch option and no RMDs are required for non-spouse beneficiaries. For the full list of rule, deadlines, and tax strategies surrounding inherited IRA’s see the articles listed below:
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.