Recently we referenced a new IRS proposal that would change the Required Minimum Distribution
(RMD) formula for qualified retirement plans and accounts. The short explanation is that as individuals reach their required minimum distribution age, they will now be required to take out less each year then they previously had to. That is because the IRS is now expecting the average person to live longer than ever. For more context, let’s break down what RMDs are and how they are calculated.
What are required minimum distributions?
Per the IRS, “Required Minimum Distributions (RMDs) generally are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 ½ years of age.” The distribution must be taken by December 31st each year, except for the first year which can be delayed until April 1st of the following year. For example, if Mrs. Smith was born February 15th 1949, she would turn 70 ½ on August 15th 2019 and have a RMD due in 2019. Since it is her first year she can delay it until April 1st, 2020, but she will still need to take her next RMD by December 31st, 2020. Delaying just means you get to take two RMDs in the next year, which we believe can be problematic if not planned for.
This applies to retirement accounts such as IRAs, SEP IRAs, SIMPLE IRAs, or workplace retirement plans like 401(k)s, 403(b)s, & 457s. There are a few exceptions for workplace retirement plans if you are still working and own less than 5% of the business, in which case it starts when you retire. It also doesn’t apply to Roth IRAs, but they do to Roth 401(k)s, which is often overlooked.
How are Required Minimum Distributions calculated?
RMDs are calculated by dividing your December 31st account balance from the prior year by a life
expectancy factor published by the IRS in Publication 590-B. There are three different tables that you
might use depending on your situation.
- Joint and Last Survivor Table – use this if the sole beneficiary of the account is your spouse and
your spouse is more than 10 years younger than you - Uniform Lifetime Table – use this if your spouse is not your sole beneficiary, your spouse is not
more than 10 years younger, or if you are single - Single Life Expectancy Table – use this if you are a beneficiary of an account (an inherited IRA)
Let’s revisit Mrs. Smith again. Prior to the most recent proposed changes we mentioned, if she had an IRA balance of $100,000 on December 31st of the year prior to her turning 70 ½ she would consult the IRS Uniform Life Table and find a distribution period of 27.4 for a 70-year-old. That means that the IRS is estimating she will live an additional 27.4 years. To calculate her RMD she must take her account balance ($100,000) and divide it by her distribution period (27.4) to get her required distribution of roughly $3,650.
Every year after she would find her balance from December 31st of the previous year and repeat this
exercise using the Uniform Life Table. Over time the distribution period (or life expectancy) decreases meaning the IRS requires a minimum distribution that is larger than the year before, at least in percentage terms. In reality, most people have an increasing RMD in dollar terms until the growth of their account balance can’t keep up with the withdraw percentage. As their account balance decreases the absolute amount required to be withdrawn decreases even if the percentage increases.
One final note about the calculations of RMDs. If you have multiple IRA accounts, you can total up all of the RMDs you must take and withdraw them from just one account instead of spreading them out across all of the accounts. For example, if Mrs. Smith had three $100,000 IRAs, she could take one large withdraw of about $10,950 ($3650 x 3) from one IRA and leave the other two untouched.
Unfortunately, you can’t do this across account types, meaning your RMD attributed to your 401(k) can’t come out of your IRA, and vice versa.
What happens if I miss a Required Minimum Distribution?
This is a bad news, good news situation. The bad news is if you miss an RMD you have to catch up by taking the distribution as soon as possible and still suffer an IRS penalty of 50% of the amount that should have been distributed. That is a really big penalty. The good news is that this happens often enough the IRS has a formal process to admit the mistake, correct it, and apply for a waiver on the tax penalty. Here are the steps to take.
First, take the missed RMD as soon as you notice the issue. Then, after receiving your RMD download IRS form 5329, and complete it. If you missed more than one year of RMDs you will need to complete a new one for each year missed. Finally, attach a letter explaining your mistake and confirming that you have corrected it. Mail all this in and wait. Every case is different, but it has been our experience that the IRS grants a high percentage of these waivers, however nothing is guaranteed.
Required Minimum Distribution recap
There are many things that impact your Required Minimum Distribution including your age, marital
status, and amount invested. Since these distributions are taxed as ordinary income, having a plan to
proactively estimate them can be helpful. This is especially true if you are lucky enough to not need all your RMD for expenses due to social security, pensions, or other forms of income.
The recent proposed change by the IRS to the life expectancy tables will lower the required amount
which we feel should provide everyone with more flexibility when building a plan for their retirement
income.