Most people don't start thinking about their taxes until well into the New Year, but with some tax laws, you don't have the luxury of procrastination. One particularly onerous tax law requires retirees who were 70 or older by June 2015 to take action before year's end, and if they don't, they could face an unusually large 50% penalty. To avoid the penalty, those covered under the law have to take a required minimum distribution from their IRAs, 401(k)s, or other qualifying retirement assets.
The ABCs of RMDs
Required minimum distributions are designed to put a limit on the amount of tax deferral that you can get using tax-favored retirement accounts. Lawmakers didn't want those who were wealthy enough not to tap their IRAs and 401(k)s in retirement to get an unfair advantage, but they also knew that many taxpayers would do whatever they could to put off paying taxes as long as possible.
The RMD rules therefore require retirees to start taking distributions from their retirement accounts at a certain age. In the year that you turn 70 1/2 years old, you have a special one-time extension that gives you until April 1 of the following year to take a distribution. After that, though, future distributions must be made by the end of the calendar year.
In addition, anyone who has inherited an IRA, 401(k), or other retirement account and chosen to stretch their distributions throughout their lifetimes also has to take a required minimum distribution. Again, lawmakers didn't want multigenerational tax benefits on retirement accounts and so limited the ability of heirs to extend the tax deferral that the accounts offer.
If you don't take your required minimum distribution, then the IRS charges a penalty of half of the amount that you should have taken. The potential for taking a 50% haircut on your retirement income is enough to give you a big incentive not to forget about your RMD.
How much do you need to take out to avoid the penalty?
The amount of the required minimum distribution you have to take out of your retirement accounts depends on your life expectancy. A worksheet available from the IRS [opens PDF] provides the framework for making the calculation.
Essentially, though, the idea is that you need to take out a fraction of your assets equal to one year's share of the retirement account principal. So for example, if you were 78 this year, your life expectancy is 20.3 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 20.3, or a bit less than 5%. As you grow older and your life expectancy declines, the percentage of your remaining retirement account balance that you must withdraw grows.
An alternative strategy for dealing with RMDs
If you don't like dealing with required minimum distributions, there's something you can do to avoid them once and for all: convert your traditional retirement accounts to a Roth IRA. Roth accountholders are not required to take RMDs, letting them stretch out the tax-free benefits of the Roth throughout their lifetimes. The price is that you have to pay current income tax on the amount that you convert. Note also that those who inherited a Roth IRA or 401(k) from someone else still have to take RMDs just as they would on a traditional retirement account.
Most retirees don't have a major problem with RMDs as they actually need their financial resources to cover the expenses of retirement living. For those who think they can leave their retirement accounts untapped, however, it's important to understand how the RMD rules require you to take money out -- or face a huge financial penalty.