Required Minimum Distributions
Third in our series of articles related to saving for retirement.
Various forms of retirement savings are "tax deferred," meaning that the savings put into them is money on which you've not yet paid income taxes. This may be because it was pre-tax payroll deductions into your company's 401(k) or because it was contributions you made to your IRA and then got to deduct on your income taxes. Further, if you made non-deductible contributions to an IRA, the growth of the money so invested is not taxed until it's distributed from the IRA (typically into a taxable account, and from there, spent). In short, one way or another, you've accumulated some money on which you've never paid income taxes.
And Uncle Sam wants his due.
In the most common case - an account owned by you and to which you (and/or your employer) have been contributing on your behalf for many years - Required Minimum Distributions (RMDs) must start being taken in the year in which you turn 70-1/2. Actually, there's a small loophole, since you may delay that first, but only that first distribution until the following April 1, though this has the potentially unfortunate side effect of you having to take two distributions in that year.
RMDs are designed to, theoretically, liquidate your account and thus have you pay taxes on the whole account value over the course of your expected lifetime. The IRS has a set of rules to determine how much to take out. For a single person, or a married person whose spouse is less than 10 years younger than him or her, the IRS uses a "uniform lifetime life expectancy" table. It's included in IRS Pub 590 (see below for links), Appendix C, Table III.
Suppose Bob 's birthday is in October and he'll turn 71 this year. That means he turned 70-1/2 in April. Bob needs to take his first RMD either this year or by April 1 next year. Since he doesn't want to take two RMDs next year (because that'll more than double the additional taxable income he'll be taking due to the RMDs), he needs to take his RMDs by the end of this year. Since Bob will be 71 this year, that's the age that gets used to look up his life expectancy in the tables. The life expectancy in the tables is called the "distribution period" - meaning the number of years of which the distributions will theoretically be spread. For Bob, age 71, the distribution period is 26.5 years. So now Bob looks up the value of his IRA account as of the end of last year, regardless of what it's worth right now. Suppose the IRA was worth $100,000. 1/26.5 of that is $3773.58. That's how much, at a minimum, Bob needs to take as a distribution from the IRA. Next year, Bob needs to take the distribution by the end of the year and he'll use this year's year-end-balance and the lookup in the table for age 72.
Unfortunately, the rules can be much more complex than that. The next step up in complexity is if Bob, who is turning 71 this October, is married and his wife is more than 10 years younger than him. If his wife is the sole beneficiary of Bob's IRA, then he may use a more favorable table. The idea is that since Bob's wife is so much younger than him, they'll let him take smaller bits out based on his joint life expectancy with his wife. A joint life expectancy (the number of years until they're both expected to die) is much longer. The IRS ignores this if they are less than 10 years apart, but suppose Bob's wife, Irene, will be 52 this year (it doesn't matter when in the year her birthday falls). Instead of using the single-life table that we used for Bob earlier, we use Table II in that same publication. This table is a two-dimensional table - one age down the side and another age across the top. For a couple who are 71 and 52, the joint expectancy is 33.3 years. So the calculation is now 1/33.3 of Bob's last-year-end balance, or $3000 instead of the much higher $3774.58 we came up with when Bob wasn't married. This is potentially a very sizable difference, especially if Bob's got other assets and/or income and doesn't actually need to spend down the IRA to cover his cost of living.
One more point about RMDs with respect to the individual owner - the RMDs apply to all IRA accounts you have. Suppose Bob has three different IRA accounts, one at Vanguard, one at Fidelity and one at Scottrade, for example. To calculate the RMDs he needs to take, he may sum up the total of the three accounts as of the end of the last year, and the RMD he takes may come from any combination of the accounts he'd like. If he wants to take the entire RMD from only one of the accounts, that's just fine. This may cause the other places to contact him to remind him and/or make sure he's taken the RMDs (that's a nice courtesy, by the way - missed RMDs can cause huge penalties). But so long as he's taken the full RMD necessary, regardless of which account(s) it came out of, he's fine.
How can Bob avoid taking RMDs? If this were not an IRA but rather, a 401(k) at Bob's place of work, he may be able to hold off on taking these RMDs if he's still working there (subject to a couple of rules, most notably, he cannot be the owner of the company). This ability to avoid taking RMDs is one of a few good reasons to not roll over an employer-based retirement plan into an IRA but rather, if possible, roll it into your current employer's plan. (Another great reason, by the way, is to make it easier to do Roth conversions from other IRAs).
That's the basics of RMDs. Note that this is just the beginning, unfortunately. If the owner if an IRA has died, the beneficiary of the IRA may have to take RMDs. The rules for inherited IRAs can be complex. A few notes on some of the cases:
If your spouse dies and you've inherited the IRA, the rules are different depending on whether or not your spouse died on or after April 1 of the year after he or she had turned 70-1/2. If your spouse had not crossed that age threshold, you may simply roll the IRA into your own IRA account as if it had always been yours (and subject to your own future RMD rules). If your spouse was over the age noted above, you must take the spouse's RMD for the year in which he or she died, then roll the rest into your own account. Or, regardless of the spouse's age, you could leave the IRA in your deceased spouse's name, but you may have to start taking RMDs based on your age regardless of whether you're over 70-1/2 or not. Or there's a 5-year rule wherein you take distributions over a 5 year period, but that's rarely the most tax-efficient option.
If you are a non-spouse beneficiary, you've got to take RMDs, too, using a different single-life table (which is not as favorable as the one Bob used above). Non-spouse beneficiaries may not roll an inherited IRA into their own. The beneficiary would contact the IRA custodian and move the deceased IRA (or his share of it) into a different type of IRA account, an "inherited IRA" account. The custodian will know how to handle this. The inherited IRA must take RMDs - or it must be distributed in its entirety very quickly. There may be substantial opportunities to defer taxes on the bulk of the IRA if the beneficiary is young - RMDs for very young people are very small because they have such long life expectancies.
If a trust is the beneficiary of the IRA, the rules may be even more complex. It's possible for a trust to distribute the IRA according to the rules for RMDs for individual beneficiaries, but it's tricky and the trust must be set up exactly right. Do not name a trust as the beneficiary of an IRA without consulting carefully with an attorney who has experience with this. If it's done incorrectly, the entire IRA will have to be distributed quickly - and taxed.
For more information, see IRS Pub 590, available from the following links as either web pages or as a PDF:
As a web page: http://www.irs.gov/publications/p590/ch01.html
As a PDF: http://www.irs.gov/pub/irs-pdf/p590.pdf
An excellent SmartMoney column from Jan 2011 about how to handle inheriting your spouse's IRA: http://www.smartmoney.com/retirement/planning/inheriting-your-spouses-ira-7951/