Required Minimum Distribution Mistakes You Want to Avoid
A few weeks back, I wrote about issues and pitfalls related to IRA required minimum distributions (RMDs) in the year of death of the IRA owner (see "Year of Death Required Minimum Distributions for IRAs"). This sparked conversations with clients regarding other mistakes to avoid for RMDs from not only IRAs, but other tax-favored accounts such as 401(k) accounts.
To refresh, a RMD is the amount retirement account owners must withdraw from their IRAs and 401(k)s and pay income tax on each year. RMDs are required after age 73, except for Roth IRAs, which do not have RMDs for the original account owner. For 401(k) plans, there is also a limited RMD exception for employees still working for the plan sponsor who do not own 5% or more of the company. Those employees can delay RMDs for as long as they continue to be employed by the sponsor.
The problem is, it is easy to get sideways with the RMD rules, and when you do, the result can have expensive tax consequences, not to mention damaging your overall financial plan. The danger seems to be especially problematic for those who have multiple retirement accounts, since that can make calculating your RMDs more complex.
Here are some RMD mistakes I have seen over the years you will want to avoid.
First, and probably most common, is flat out forgetting to take your RMD for the year. The penalty for failing to take an RMD is an egregious 50% of the RMD amount, and that is on top of the regular income tax that is due. Whatever you do, once RMDs must start, don't forget to take them. Fortunately, there is a way to request an IRS waiver of the penalty if "reasonable cause" is established, and while the IRS often will grant such a waiver in the right circumstance, it's not assured. Typically, just "forgetting" doesn't meet the standard of reasonable cause.
Closely related to the above is simply taking out the wrong amount. The RMD is a factor of the value of the account, your age and life expectancy per IRS tables. The IRS has RMD calculators that are helpful, but you need to know that the RMD is based on the value of your account balances as of December 31 of the previous year. For IRAs, it is based on the sum total of all IRA accounts added together.
Also, here's a tip – if you have multiple IRAs, you don't have to withdraw an RMD from each account. You can draw the total RMD from any single account or combination of accounts. It's also worth mentioning here that this rule is different for 401(k) plans. You must take a RMD from each 401(k) account to which that RMD is related.
Another similar mistake is missing an RMD deadline. Your first RMD will be due by April 1 of the year after you turn 73. Future RMDs then are due by December 31 of each year. Here's a twist – if you wait and take the Year 1 RMD in the Spring of the next year, you still have to take the Year 2 RMD by the end of that same calendar year.
Did you catch that? That's two RMDs in the same year, which might not be a good result. This could bump you to a higher income tax bracket, cause your Social Security income to be taxed (or more of it) and/or result in an increase in the cost of Medicare. Thus, be careful before you decide to delay that first RMD past the end of the year in which you reach age 73.
Another common mistake is actually not realizing that RMDs (or any distribution for that matter) are taxable income, and thus, being unprepared for the tax bill at filing time. Also, there are the consequences mentioned already in the preceding paragraph. Other implications could include negatively affecting a child's college financial aid eligibility, limits on your charitable contribution deductions and imposition of the net investment income tax imposed on individuals whose income exceeds certain levels.
Hopefully by now you can see that when it comes to RMDs, there is a mine field of possible issues out there to deal with. This is one of those areas where I strongly believe you should consult a qualified financial professional to help you develop a long-term financial plan for determining and managing your RMDs for maximum financial health.