The required minimum distribution (RMD) rules limit the extent to which an individual can use the tax deferral of an IRA or other qualified retirement plan. The RMD rules dictate when distributions must be made from the retirement plans of certain taxpayers.
The required minimum distribution rules apply to qualified annuities. A qualified annuity is an annuity that is held in a traditional IRA or other qualified retirement account. Qualified fixed, variable and index annuities are all subject to the required minimum distribution rules.
The rationale behind the RMD rules is that Congress provided the tax benefits of IRAs and other qualified retirement plans to help individuals save for retirement, but the benefits are to be used primarily for the original account owner’s retirement. They aren’t to be used as estate planning tools, to accumulate wealth protected from income taxes, or to transfer wealth to other individuals.
The required minimum distribution rules are established in Internal Revenue Code §409(a). But the tax code section isn’t very specific. The details of the RMD rules are in the IRS regulations issued under §409(a).
Failure to take the required minimum distribution from an IRA or other qualified retirement plan can result in the imposition of perhaps the highest penalty in the tax code. The penalty is 50% of the amount that should have been distributed from the plan but wasn’t. The penalty is in addition to any income taxes due on the distribution. The penalty might be waived if the account owner qualifies for one of the exceptions and files Form 5329 with the IRS requesting a waiver of the penalty.
The required minimum distribution rules have changed significantly in recent years.
One rule that hasn’t changed is that original owners of Roth IRAs and Roth 401(k) accounts do not have to take RMDs during their lifetimes. They can let the accounts compound without taking distributions if they wish.
Original owners of traditional IRAs, 401(k)s, and other defined contribution plans must take RMDs after reaching a specified age. RMD rules also apply to traditional pensions, known as defined benefit pension plans. But the plan sponsors are responsible for complying with the rules, so their application to defined benefit plans isn’t discussed in this article.
Originally the age that triggered RMDs was 70½. Anyone who reached age 70½ before 2020 is subject to the original rules. The first RMD had to be taken by April 1 of the year after the year in which the owner turned 70½. RMDs had to be taken by December 31 of each year after the year in which the owner turned 70½.
Owners who turned age 70½ after 2019 don’t have to take RMDs until they reach age 72. The first RMD has to be taken by April 1 of the year after the owner turns 72. Subsequent RMDs have to be taken by December 31 of each year after the year in which the owner turned 72.
A simple calculation determines the amount of the RMD.
First, the account owner determines the account balance as of December 31 of the year before the RMD is to be taken. For example, 2022 RMDs are calculated using the account balance as of December 31, 2021.
Second, the account owner determines his or her life expectancy factor using the life expectancy tables published by the IRS in the back of IRS Publication 590-B. There are three life expectancy tables. Table I is used by beneficiaries who inherit IRAs and aren’t subject to the 10-year distribution rule. Table II is for an IRA owner whose spouse is the sole beneficiary of the IRA and is more than 10 younger than the owner. Table III is for other IRA owners.
Third, the account balance is divided by the life expectancy factor. The result is the RMD for the year.
The calculation is repeated each year. The new account balance as of the previous December 31 is used to begin the calculation. This automatically adjusts the calculation for changes in the investment values and for any distributions in the previous year that exceeded the RMD.
The annuity balance or investment amount is included in the value of the IRA or other qualified retirement plan when computing the RMD. Payments received from the annuity and distributed to the account owner or beneficiary are considered part of the RMD for the year.
Non-qualified annuities are annuities purchased with after-tax income. Since the individual has already paid taxes on the money invested in the annuity, the annuity value is not subject to the required minimum distributions.
Immediate annuities also aren’t subject to RMDs. An immediate annuity is one in which the annuity owner deposited a lump sum with the insurer in return for the promise of the insurer to pay a fixed stream of income to the individual. The income payments begin with one year of when the deposit with the insurer is made..
When an immediate annuity is purchased in an IRA or other qualified retirement plan, the IRS considers the periodic payments to automatically satisfy the RMD rules. Other amounts in the qualified retirement plan still are subject to the RMD rules.
Another exception to the required minimum distribution rules is the qualified longevity annuity contract (QLAC). The portion of the IRA that is invested in a QLAC isn’t included when computing RMDs.
A QLAC is a deferred annuity contract. You give a deposit to an insurer, and it promises to make a specific annual payment to you each year for the rest of your life, beginning in a year you select. The payments can be delayed from two years to 45 years after you buy the annuity, but they have to begin by age 85.
The QLAC can be used for the lesser of 25% of your IRAs or $125,000. The limit is per person, not per IRA.
What you don’t know about your retirement finances can hurt you. Learn more about all aspects of your retirement finances, especially the most important recent changes, through Retirement Watch. The only publication to cover all the elements of retirement finance, it has been edited for more than 30 years by America’s #1 retirement expert, Bob Carlson. Carlson was trained as an attorney and accountant and has served as Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System (which has more than $4 billion in assets) since 1995.
Katie Kao is an editorial intern with Eagle Financial Publications.