Many people wait until April to start thinking about their taxes, but the IRS doesn't always give you that much time to procrastinate. One of the harshest penalties in the tax code applies to retirees who were age 70 or older by June 2016, requiring them to take required minimum distributions from IRAs, 401(k)s, and other tax-favored retirement accounts by Dec. 31. If they don't, a draconian 50% penalty applies. Below, we'll look at why this penalty exists and what you have to do to avoid having to pay it.
Tax-favored retirement accounts are a big boon for savers, but the required minimum distributions limit how long you can enjoy the tax deferral that such accounts offer. Otherwise, many taxpayers would do as much as they could to avoid tapping IRAs and 401(k)s, instead letting them grow and putting off paying taxes until they absolutely needed the money in those accounts.
The RMD rules require retirees to start taking distributions from their retirement accounts in the year that you turn 70 1/2 years old. What that means for practical purposes is that if you had your 70th birthday this year in June or earlier, you'll be on the hook for taking an RMD for the first time. That first year, you get a special one-time extension that gives you until April 1 of the following year to take a required minimum distribution. After that, you have to take future RMDs by the end of the calendar year.
In addition to retirees, any beneficiary who inherited an IRA, 401(k), or other retirement account and chose to stretch their distributions throughout their lifetimes must also take a required minimum distribution. As with the retirees themselves, Congress didn't intend to turn tax-favored retirement accounts into an unending multigenerational tax break. RMDs put a final limit on the length of time that heirs can take advantage of tax deferral.
The penalty for not taking a required minimum distribution is high. The IRS calculates the penalty by looking at the amount you should have taken and multiplying it by 50%. Losing half your RMD to a tax penalty is plenty of reason not to put off RMDs beyond the end-of-year deadline.
How large an RMD do you need to take in order not to pay the penalty?
Your life expectancy is the primary determining factor in figuring out how much you need to take from your retirement accounts as a required minimum distribution. This IRS worksheet [opens PDF] has all the specific details in helping you make the calculation.
The general idea behind calculating RMDs is that you need to take out a fraction of your account balance every year, and that fraction is based on the idea that you'll withdraw your balance steadily over the course of your life expectancy. For instance, those who were age 73 this year have a life expectancy of 24.7 years according to the IRS uniform life table. Your RMD would therefore be your retirement account balance at the end of the previous year divided by 24.7, or a bit more than 4%. As you can see on the worksheet, as you grow older and your life expectancy declines, the percentage of your remaining retirement account balance that you must withdraw grows.
Don't want to deal with RMDs? Convert to a Roth IRA
There's one thing that you can do that will allow you not to have to deal with required minimum distributions in the future. Converting your traditional retirement accounts to a Roth IRA avoids the RMD provisions, because Roth IRAs don't require their accountholders to take RMDs. That allows you to enjoy the tax-free benefits of Roth IRAs for the rest of your life.
However, there's a cost to converting: you have to pay current income tax on the amount that you convert from a traditional IRA or 401(k) to a Roth. Also, this limitation on RMDs only applies to the original Roth IRA accountholder. Anyone who inherits a Roth from someone else still has to take RMDs just as they would on an inherited traditional IRA or 401(k).
If you're tapping your retirement accounts already, then the need to take required minimum distributions won't be a big burden. But for those who aren't familiar with the RMD rules, the 50% penalty can come as a huge shock -- especially since it's so easy to avoid it once you know about it.