Don’t let required minimum distributions blindside you.
Most of us think often about the best ways to build up our retirement accounts. 401k and traditional IRA accounts are generally funded with pre-tax money. If you are lucky or skillful enough to grow those balances substantially, you may run into unexpected problems.
Tax deductions on money contributed seemed like no-brainers initially. You deferred federal income tax on those amounts, plus anything they earned later, until your money would be withdrawn.
Like all "buy now, pay later" deals, the benefits accrued immediately while the pain was pushed down the road. IRS rules require you to start withdrawing money from most retirement plans (excepting Roth IRAs) no later than the year you turn 70 ½ even if you are not yet retired.
Why do they force you to do that? The government wants your money and it is tired of waiting for it.
If you started your IRAs early in life and achieved reasonable success, you and your spouse might find each of you holding seven-figure IRA account balances.
Once Required Minimum Distributions (RMDs) kick in, the taxman dictates that, in each subsequent year, you must withdraw an amount based on your projected life expectancy.
Washington charges a staggering 50% penalty in additional to any tax owed if you mess up on RMDs. Messing up is defined as skipping a mandatory withdrawal or simply taking less than what the IRS determined you should.
If a bank or commercial business charged a 50% penalty for late, or less than full payments, there would be a public outcry. That is "business as usual" for the IRS, though.
The IRS refuses to give clear and easy instructions on how much you need to take out. They do provide tables that require a bit of input and intelligence to figure RMDs accurately.
My example uses the simplest form – for Single Life Expectancy based on age in the year of the withdrawal. If you manage to stay alive to age 100, the friendly actuaries at the IRS generously figure you could make it to almost 103.
To determine your IRA’s RMD you need to know the Dec. 31 combined value of all your IRA accounts, if you own more than one, from the previous calendar year. Then you must convert your projected life expectancy (from the table shown above) to a percentage.
If your 70.5-year-old spouse had similar success with their IRA, they also have to take an annual RMD. Your family's joint income would include an extra $117,648 in 2014. That extra "income," which represents nothing more than a location shift, from your retirement accounts to your non-retirement accounts, becomes taxable at your highest marginal ordinary income tax rate.
It will also automatically trigger taxation on 85% of any social security benefits received that year.
If a couple were each 80 years old, with million-dollar IRAs, their combined RMD would be 1/10.2 = 9.80% of $2,000,000 or $196,000 just for that year. Add in social security benefits, dividends and interest, any pensions you might be collecting and you could become unexpectedly subject to tax rates of 43.4% — the revived top bracket of 39.6% plus the 3.8% Obamacare surcharge, just at the federal level. Some state and local governments add their own income tax levies to retirement distributions.
Things get very complex if you die while still holding money in traditional IRA accounts. If your spouse is your sole beneficiary, it’s not too bad. Heirs should be sure to get good advice before deciding how to proceed.
You can see answers to frequently asked questions regarding RMDs at IRS.gov but remember — the IRS is not going to provide any help in minimizing the tax bite.