Navigating the RMD Minefield

IRAs seem simple at first. You make contributions and manage the investments. Over time, however, IRAs become more complicated and even inconvenient. IRAs become especially troublesome for people as they begin to take distributions and especially after they reach age 70½ and beyond, because of the required minimum distributions.

The RMD rules are not what people expect, and that leads to expensive mistakes and missed opportunities. The IRS conducted studies in recent years that found many people are making mistakes with their RMDs. That’s led the IRS to change its audit and enforcement procedures so that it can catch more of those who don’t follow the rules.

RMDs also create financial planning problems for people. The purpose of RMDs is to force the IRA to be spent down during a person’s life expectancy, whether you need the cash or not. The RMD schedule increases the percentage of the IRA that must be distributed each year after age 70½. That doesn’t match the spending patterns or income needs of most people, especially those with large IRAs and multiple sources of retirement cash flow. They don’t need all of the forced distributions. The distributions increase income taxes and can push you into a higher income bracket that triggers higher Medicare premiums and other stealth taxes. RMDs also limit the ability of IRAs to serve as emergency spending accounts or legacies for their heirs.

The adverse consequences for breaking the rules are not the only reason to know the RMD rules. (The penalty for an incorrect RMD is 50% of the amount you should have distributed but didn’t.) The RMD rules provide planning opportunities and have flexibility. By carefully considering them you can reduce taxes or increase after-tax wealth. The earlier you begin planning, the better, but you can take advantage of the options.

RMDs from traditional IRAs are required after age 70½. The first RMD is required by April 1 of the year after you turn 70½. For example, those who turn 70½ in 2015 must take the first RMD no later than April 1, 2016, but also can take that first RMD anytime in 2015.

It’s often best to take the 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 delay taking that first RMD until near the April 1 deadline you’ll have two RMDs in the same year, the year after you turned 70½. Taking two RMDs in one year could push you into a higher tax bracket and trigger the stealth taxes.

In the years after you turn 70½, you must take an RMD each year by December 31.

You also have to take RMDs from traditional employer plans, but the rules are a bit different. In this visit, we focus only on RMDs from traditional IRAs.

There are no required minimum distributions for original owners of Roth IRAs. But if you convert a traditional IRA to a Roth IRA during the year, you are required to take the year’s RMD from the traditional IRA. It isn’t part of the conversion.

RMDs also are required of beneficiaries who inherit either traditional or Roth IRAs. Those rules are different. We discussed them in the past and won’t discuss them in this visit.

To compute your RMDs start with the ending value of the IRA on Dec. 31 of the previous year. When you turn 70½ in 2015, you use the closing value for 2014, even if you wait until early 2016 to take that first RMD. In years after you turn 70½, you use the IRA value at the close of the previous year. Those taking regular 2015 RMDs use the IRA values on Dec. 31, 2014.

Then, 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.Retire-mentWatch.com under the “Extras” tab. (Ignore the hyphen.)

There are three life expectancy tables. Table I is for beneficiaries (those who’ve inherited IRAs). Table II is for married IRA owners whose spouses are both more than 10 years younger than they are and are the sole primary beneficiaries of the IRAs. Every other IRA owner uses Table III, also known as the Uniform Lifetime Table.

Divide the IRA balance at the end of last year by your life expectancy for this year. If you turn 74 in 2015, your life expectancy under Table III is 23.8. If your IRA balance last Dec. 31 was $150,000, your RMD for 2015 is $6,303.

When you own multiple IRAs, compute the RMD by aggregating the balances of all your IRAs and dividing the total by your life expectancy.

Then, you have flexibility. 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 in any ratio you want. This allows you to use the RMD to rebalance your overall portfolio when it’s out of balance, use it as an excuse to sell an investment you no longer like, or simplify your finances by drawing down one IRA at a time.

An RMD doesn’t have to be in cash. Many people first have the IRA sell enough investments to generate cash for the RMD, and then distribute the cash. The tax law allows the distribution to be taken in property, and most IRA custodians allow noncash distributions. With most IRA custodians, the form to request a distribution, whether it’s an RMD or other distribution, allows you to designate whether you want the distribution to be in cash or in particular assets. Then, you designate the non-IRA account to which you want the distribution to be made. To make a property distribution, if you don’t already have a taxable account at the custodian, most brokers and mutual fund companies simply set up a new taxable account to receive the distribution.

Consider a property distribution when you have other sources of cash and want to continue owning the asset in your portfolio or don’t want to incur any costs of selling 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. That value also is your tax basis in the asset.

You can take RMDs during the course of the year on any schedule you want, as long as you take distributions totaling at least the minimum amount by Dec. 31. There are different factors to consider when deciding on the timing of your RMDs.

A few years back a study by mutual fund firm T. Rowe Price concluded that an IRA owner who waited as late as possible in the year to take RMDs accumulated a bit more money over time than an owner who took RMDs at the start of the year. The study assumed the IRA owner took distributions in cash and covered 1993 to 2003. Since stocks generally rose during that time, it made sense to leave the money to appreciate in the accounts for as long as possible.

The result would have been different if the accounts were more conservatively invested or markets weren’t booming. In fact, in the Price study, the late-distributing IRA owner was far ahead of the other IRA owner through 1999. After that, the early-distributing IRA owner rapidly caught up. Only the bull market of 2003 pushed the late-distributing owner back into a clear lead. The timing also wouldn’t matter if distributions were taken in property instead of cash.

There are other factors to consider, and these generally favor taking RMDs early in the year.

Early distributions ensure 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.

Don’t forget to either factor the RMD in your estimated tax payments for the year or have the custodian withhold an appropriate amount for taxes. You don’t want to be hit with an underpayment of estimated tax penalty.

Keep in mind that you always can take more than the RMD. The RMD is the minimum amount you are required to distribute.

RW March 2015.