The IRS is cracking down on IRA mistakes, and improper required minimum distributions (RMDs) are a major target. The IRS receives enough in-formation from IRA custodians to identify people who might have made RMD mistakes. The penalty for an incorrect RMD is 50% of the amount you should have distributed but didn’t.
The IRS isn’t the worst problem. Many IRA owners when planning RMDs overlook opportunities to reduce taxes or increase after-tax wealth. You have flexibility and choices, and you need to carefully consider them.
RMDs are required after age 70½. The first RMD is required by April 1 of the year after you turn 70½. For example, those who turned 70½ in 2012 must take the first RMD no later than April 1, 2013, but can take it anytime before then, including in 2012.
It’s often best to take that first RMD in the year you turn 70½, because you’ll have to take the second RMD by Dec. 31 of the following year. If you wait to take the first RMD, you’ll have two RMDs in the second year. When those who turned 70½ in 2012 wait until early 2013 to take the first RMD, they’ll have another RMD to take by Dec. 31, 2013. Taking two RMDs in 2013 could push you into a higher tax bracket, reduce tax breaks, and cause other problems.
In the years after you turn 70½, you must take an RMD each year by December 31.
There are no required minimum distributions on Roth IRAs, except for beneficiaries. You also have to take RMDs from employer plans, but the rules are a bit different. In this visit, we focus only on RMDs from traditional IRAs.
RMDs are simple to compute. Start with the ending value of the IRA on Dec. 31 of the previous year. When you turned 70½ in 2012, you use the closing value for 2011, even if you wait until early 2013 to take that first RMD. In years after you turn 70½, you use the IRA value at the close of the previous year. Your 2012 RMD uses the IRA value on Dec. 31, 2011.
The second step is to find your life expectancy in the tables furnished by the IRS in Publication 590, available free on the IRS web site at www.irs.gov. We also provide the most-used table on the members’ web site at www.RetirementWatch.com under the “Extras” tab.
There are three life expectancy tables. Table I is for beneficiaries (those who’ve inherited IRAs). They have to take RMDs over their life expectancies. Table II is restricted to married IRA owners whose spouses are both more than 10 years younger than they are and are the sole principal beneficiaries of the IRAs. Every other IRA owner uses Table III, also known as the Uniform Lifetime Table. This is the table on our web site.
To find your RMD for the year, divide the IRA balance at the end of last year by your life expectancy for this year. If you turn 74 in 2012, your life expectancy under Table III is 23.8. If your IRA balance was $150,000, your RMD for 2012 is $6,303.
When you own multiple IRAs, you have flexibility. The RMD is computed by aggregating the balances of all your IRAs and dividing the total by your life expectancy. You can take the RMD from the IRAs in any combination you want. Take it all from one IRA or take different amounts from the IRAs. This allows you to use the RMD to rebalance your portfolio when it’s out of balance or simplify your finances by drawing down one IRA at a time.
An RMD doesn’t have to be in cash. The tax law allows the distribution to be taken in property, and most IRA custodians also allow this. Normally when you’re completing the form requesting the distribution, you designate whether you want the distribution to be in cash or in particular assets. Most brokers and mutual fund companies simply set up a new taxable account to receive the distribution or make the distribution to an existing account you have. By making a property distribution, you don’t have to sell an asset you want to continue owning or incur the costs involved with selling and then repurchasing the asset. When you take a distribution of property, the fair market value on the date of the distribution is included in your gross income, regardless of what happens to the asset’s price the rest of the year.
RMDs also can trigger estimated tax penalties. You’re supposed to pay estimated taxes evenly throughout the year. If you try to bunch the estimated taxes in the last payment for the year, the IRS will compute a penalty. When you earn income unevenly throughout the year, you can avoid the penalty by using the annualized income installment method and completing the appropriate section of Form 2210. But it’s complicated. Details are in free IRS Publication 505.
A better approach to avoid the penalty is to have the estimated tax withheld from your RMDs. The IRS considers withheld taxes to be paid evenly during the year, no matter when they are withheld. So, you can avoid the underpayment of estimated taxes penalty by having taxes withheld from RMD no matter when they’re made. Check with your IRA custodian first. Some limit the types of distributions on which they’ll withhold taxes.
It’s usually best to take RMDs early in the year. This ensures the task is not forgotten or left to a last-minute rush when IRA custodians are busy and likely to make mistakes or perform tasks late. Taking the RMD early in the year also ensures there is no problem in case anything should happen to you during the year. Executors must take RMDs from the IRAs of those who passed away during the year. But many overlook this or have to take a lot of time to accumulate enough information to know how much they need to take.
Remember, you always can take distributions greater than the RMD.
As we discussed in past visits, you might want to withdraw substantially more than the RMD as a strategy.
One reason is that the RMD calculations have the RMDs increase over time. They increase substantially as you are in your later 70s and older. I often hear from readers who are forced to take RMDs that far exceed their spending needs. This increases their income taxes, causes more of their Social Security benefits to be taxed, triggers higher Medicare premiums, and can have other negative effects.
Another reason to consider taking much higher distributions is the prospect for higher tax rates in the future. It’s a good idea to defer taxes when you’ll be in the same or a lower tax bracket in the future, but not when you’ll be in a higher tax bracket.
You simply could take distributions exceeding the RMD each year, pay the taxes, and put the after-tax amount in a taxable account. IRS distributions are taxed as ordinary income, regardless of whether the distributions represent interest, dividends, long-term capital gains, or other types of income. By taking distributions early and investing them in a taxable account, future investment returns can be tax-advantaged, and you can manage the account to reduce future income taxes.
Having the money in a taxable account also can provide benefits for your heirs. When an IRA is inherited, there is no increase in the assets to their current fair market value. The heirs pay ordinary income taxes on the distributions just as you would. But when a taxable account is inherited, the basis of the assets is increased to their fair market value, if they’ve appreciated. The heirs can sell the assets tax-free shortly after inheriting them. Gains accruing during your lifetime and after the IRA distribution avoid taxes.
Another option, as we discussed recently, is to convert a traditional IRA into a Roth IRA. You pay taxes as though the converted amount had been distributed, but no RMDs are required after the conversion until the Roth IRA is inherited. For details see our November 2012 issue or the IRA Watch section in the Archive on the members’ section of the web site.
You want to consider the effect of the excess distribution or IRA conversion on other parts of the tax return. Higher gross income can lead to reduced itemized deductions and personal or dependent exemptions. It also can trigger the alternative minimum tax, increase the amount of Social Security benefits that is taxed, and cause you to pay higher Medicare Part B premiums in two years.
You can make a charitable contribution with an RMD or other IRA Distribution. But the special contribution deal for those ages 70½ and older expired. You have to include the distribution in gross income, and you receive an itemized deduction for the amount donated to charity. Congress might reinstate the special provision at some point, but it hasn’t yet.
RW December 2012.
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