One of the realities of tax-deferred retirement accounts is the required minimum distribution (RMD). The RMD is the amount that you have to withdraw from your tax-deferred traditional IRA, 401k or other account each year. Your RMD is figured based on the balance in your IRA at the end of the previous year. If you don't take your RMD as required, you will be penalized. It is important to remember that your RMD will be added to your income, and taxed at your marginal tax rate.
Taking Your RMDs
When you start taking RMDs is based on when you turn 70 1/2. You have to take your first RMD by April 1 of the year after you reach 70 1/2. If you were to turn 70 1/2 this year, you have until April 1, 2012 to take your first RMD (this will count as your 2011 RMD, and be based on your retirement account balance at the end of 2010). However, you should realize that you will need to plan for the fact that after you take your first RMD, you will need to take another RMD by December 31, 2012 (this will be your 2012 RMD, and be based on the amount of money in your retirement account at the end of 2011). Technically, you are getting extra time to take that first RMD. If you want to avoid a big tax whammy for 2012, you can take your first RMD before the April 1, 2012 deadline, and take it during this year.
Understand that you will have to take separate distributions for different retirement plans. Your distribution from a 401k will be different from the RMD taken from your IRAs. Your tax-deferred IRAs, including SIMPLE, traditional and SEP will all be added into a total for RMD purposes. It is worth noting that the Roth IRA does not come with a required minimum distribution requirement. When you go to figure out how much to take as a RMD, you will need to consult with the Uniform Lifetime Table found in Publication 590 on www.irs.gov. If you are turning 71 in 2011, and you plan to make a RMD, you will go to the table and look at the distribution period. In this case, it is 26.5. You divide the amount in your retirement account by the distribution period. If you have $800,000 in your combined IRAs, then your RMD would be $30,189 (rounded to the nearest dollar).
If you don't take the RMD amount required, you have to pay half the shortfall as a penalty. So, if you only take $20,000 out, you will have to pay a penalty of $15,095. That's a pretty big chunk of change. This is why it's important to pay attention to your RMDs.
Reducing The Tax Bite
Depending on how much income you have during retirement, that $30,189 could really be a problem — it might even bump you up a tax bracket. And, if you decide to wait to take your first RMD until the April 1 of the following year, your AGI would jump by more than $60,000 that year. You can see why taking the RMD a little bit earlier, rather than waiting until you have to take it, might be a desirable option. Here are some other ideas for reducing your tax liability:
- Begin before 70 1/2: You can withdraw money, penalty free, from your retirement account after age 59 1/2. Start drawing down your account then. You'll not have as big an increase to your AGI, and you can reduce your IRA balance before you start taking RMDs.
- Extend your working life: As long as you don't own more than 5% of a company, you can delay your RMDs for as long as you keep working, even if you are 70 1/2.
- Consider your spouse: If you have a spouse more than 10 years your junior, and the spouse is your only beneficiary on the account, it is possible to use the Joint Life table, or the Last Survivor Expectancy table, to figure your RMD. That should lower the number a bit.
- Convert to a Roth: You can convert to a Roth IRA from a traditional IRA if you want to avoid RMDs. But that means paying income tax on the money you convert. You will have to run the numbers to see when it makes more sense to pay the tax.