There are two important ages in retirement financial planning: 59 1/2 and 70 1/2. The former marks the age when you can distribute from your retirement account – IRA or 401k – without paying a 10% penalty on the distribution. The IRS, with this penalty, gives us all a reason to keep our long term savings in place for its intended purpose – retirement income. The second date is actually April 1st of the year after the year in which you turn 70 1/2. This is the date by which you must begin taking your required minimum distributions, or RMDs. As the name suggests, this distribution is required, whether you want to distribute or not. If you don’t, there is a 50% tax penalty assessed against the amount that should have been distributed.
How do I calculate required minimum distributions?
You use a factor from a table. Take the end of the year IRA balance, and divide it by the factor.
Age of retiree Divisor
The divisor is based upon your life expectancy. At age 70, for example, the IRS expects you to live another 27.4 years.
If you are both age 70 and 70 1/2 in the same calendar year, use the factor for age 70, or 27.4. If you are 70 in one year and 70 1/2 the next, begin with the factor for age 71, or 26.59.
Say you have two traditional IRAs. One is with a bank, and the other is with a brokerage company. Each has an end-of year balance of $500,000. You turn 70 1/2 in February of this year. How much do you distribute? $500,000 / 27.4, or $18,248.18. You can take this amount proportionally from each account, or take it all from one account – your choice. The IRS’s only concern is that the entire amount be distributed.
As you can see, each year the divisor goes down, which means the RMD goes up. An account can still grow, however, while RMDs are being distributed. Continuing with the previous example, let’s say you took that RMD on January 2nd, so your IRA balances would be $481,752. You earned 6% during the year, so your end of year balance is $510,657. Next year’s RMD is calculated against this amount.
Why does the IRS force this?
From their point of view, they have “let” you invest with before-tax dollars, and have “let” your account grow without taxation. Note the air quotes. At 70 1/2 they require you to distribute, and expose those funds to taxation. Taxation occurs at ordinary income tax rates – not at the more favorable capital gains rates. There is your trade-off, then: deferral of taxation while you are in the accumulation phase (a plus) vs. higher taxation at ordinary income tax rates in the distribution phase (a minus).
Note: there is no required minimum distribution for a Roth IRA! This is one of the tremendous benefits of doing a Roth.
What if I’m still working?
You still need to take required minimum distributions from your traditional IRAs as described even if you are still working. It works differently with your employer’s retirement plan, however. If you are a less than 5% owner of the business where you are employed, you can skip the RMDs until you do retire. Furthermore, you can continue to contribute to your retirement account there. If you are more than a 5% owner, though, you must take RMDs, but you are still able to defer your salary into the retirement plan and receive your employer’s match! In that case money is both coming into your account and going out in the same tax year.
You can Google RMD table and see the divisors for older ages. Meanwhile, we hope you’ll visit the CameronDowning website, where you can see all of our blog posts, and make an appointment to come see us. Questions meanwhile? Email [email protected]