For many taxpayers, IRAs make up a big chunk of their retirement assets. It’s no wonder, considering these accounts can be a powerful tool in building finances. They offer individuals the opportunity to save while also providing tax advantages. IRAs do, however, come with strict tax distribution rules; rules that must be followed and are sometimes difficult to comprehend. The Internal Revenue Service imposes hefty penalties to account owners that do not adhere to these rules, even if they were uninformed or misinformed. We will point out some of the potential pitfalls and tax traps to avoid.
Let’s start with the basics of Required Minimum Distributions (RMDs). The beginning date for an RMD is generally April 1 following the year you turn age 70 ½. The IRS imposes a 50 percent penalty on any missed RMDs, so it is imperative that account holders know the rules. The IRS may waive this penalty for good cause, but you must immediately distribute the missed RMD and file a Form 5329. After the initial RMD, all distributions thereafter must be taken by December 31. To calculate your first-year RMD, you would use the balance of your IRA account as of December 31 of the year before you turned age 70 ½. Individuals that have multiple IRA accounts are required to calculate the RMD for each individual account; however, the total RMD can be withdrawn from one account. One caveat: You cannot satisfy an IRA RMD from a company plan; each company plan’s RMD must be taken from that plan only.
If you have a company plan, there are a couple of RMD exceptions to note: 1) The Still Working Exception and 2) The Old Money Exception for 403(b). Under the Still Working Exception, you are able to delay your RMD until April 1 of the year following your separation from service, but you must own less than five percent of the company. The Old Money Exception for 403(b) allows a grandfather rule to delay an RMD until age 75 for those 403(b) participants that have funds from a pre-1987 plan.
There is oftentimes confusion related to RMDs in the year of death and for inherited IRAs. The previously mentioned 50 percent penalty applies also to RMDs from inherited IRA accounts even if they are tax free (such as an inherited Roth IRA), so make sure you understand the rules.
Year-of-Death RMDs: If an account holder dies and has not yet taken their entire RMD for the year, the IRA beneficiary must take remaining distributions in the year of the account holder’s death and report these on his or her income tax return. The RMD for that year is calculated as if the decedent had lived for the entire year. After this year-of-death distribution, RMDs are then calculated based on the beneficiary’s life expectancy and should be taken by December 31 of each future year.
Inherited IRAs: If you inherit an IRA, the first RMD will generally be due by December 31 of the following year (special exceptions apply to spouses who inherit). In the case of multiple beneficiaries, the inherited IRA must be split into separate accounts by December 31 of the year following the plan owner’s death. If the accounts are timely split, multiple beneficiaries’ payouts are based on each beneficiary’s age; otherwise, payouts are based on the oldest beneficiary’s life expectancy. Under new IRS Final Regulations, beneficiaries used for life expectancy purposes are determined on September 30 of the year following the year of the plan holder’s death. Check beneficiary forms. Make sure you have listed the beneficiary/beneficiaries that you wish to inherit these assets.
As always, we at Maddox Thomson stand ready to help and answer any questions you may have. Let us guide you through the IRA waters for maximum benefit to you and your beneficiaries.