Required minimum distributions (RMDs) from employer-based retirement plans and traditional individual retirement accounts (IRAs) will be due Dec. 31 for most people 72 and older. Those distributions are taxable, and that can take the sparkle out of many taxpayers’ holidays.
Although you can’t avoid RMDs, you can take some steps to minimize them. And in most cases, it’s best to take those steps before New Year’s Eve.
How RMDs work
There’s a reason accountants call traditional IRAs and other retirement plans “tax-deferred plans,” not “tax-free plans.” You don’t pay taxes on your account contributions or earnings — until you take withdrawals. And there’s a deadline for how long you can wait before taking the distributions that federal tax law requires. When you turn 72, you must start taking RMDs every year. These rules apply not just to IRAs but also to 401(k), 403(b) and other retirement plans. Roth IRAs are not subject to RMDs, but Roth 401(k)s are.
RMDs are based the IRS life expectancy tables. For example, at 72, the average person is expected to live another 27.4 years. To figure the RMD for that year, a person would divide her IRA balance by 27.4. If the balance were $100,000, the person would have to withdraw $3,650, and pay taxes on the withdrawal.
With one exception, you must take your RMD by Dec. 31. The exception: When you turn 72, you have until April 1 of the following year to take your RMD and pay taxes on it. Years ago, Congress determined that it would be benevolent to give people a three-month grace period on their first RMD, says IRA expert Ed Slott. “But that’s not really a great deal, either,” Slott says. Why? Because you’ll also have to make an RMD by Dec. 31 of that same year — in effect, making two RMDs in one year and possibly pushing you into a higher tax bracket. You’re probably better off paying your first RMD in the year in which you turn 72, Slott says.
Your RMDs are based on the value of all your tax-deferred accounts as of Dec. 31 of the previous year. If you have several tax-deferred accounts, you have to figure out the RMD for each one. You may, however, take the entire RMD out of just one account. If you have already taken distributions during the year that are equal to or more than your required RMD, you don’t have to do anything else to satisfy the RMD requirement.
The penalty for not taking an RMD is severe: 50 percent of the amount you should have taken out. If you neglect to take a $3,000 RMD, you’ll owe a $1,500 penalty. Although the IRS will sometimes forgive the penalty, it’s best not to incur it in the first place.