Required minimum distributions (RMDs) are the way the Internal Revenue Service finally collects their money. You delayed the appointment for all your working years, reducing your taxable income by the amount of contributions to your 401(k), 403(b) or traditional individual retirement account.
For those of us who are dedicated savers, being forced to withdraw money from our investments can be as unappealing as a root canal. But if we’re prepared for the procedure, we can accomplish it as painlessly as possible. Let’s drill into the options.
Required minimum distributions (RMDs)
Required minimum distributions (RMDs) are the way the Internal Revenue Service finally collects their money. You delayed the appointment for all your working years, reducing your taxable income by the amount of contributions to your 401(k), 403(b) or traditional individual retirement account. The IRS put off revenue collection because — guess what? — the contributions grow and a far larger amount can be taxed upon withdrawal.
Of course, if you were smart enough to choose the Roth version (Roth 401(k), individual Roth or both), you paid the tax before you made the contributions, so no tax will be due at withdrawal in retirement. In fact, except for inherited Roths, you won’t be required to take an RMD at all. You can withdraw from a Roth as needed or leave it untouched to grow tax-free.
You can begin withdrawals once you reach age 59½, but you’re not compelled to do so. Do it before 59½ and you not only pay regular income taxes, but also a 10% penalty on the whole withdrawal for an IRA, only on the earnings for a Roth.
There are certain exceptions: medical hardship, purchase of a first home, college (for a Roth). With a Roth, you can always withdraw the amount of your contributions; earnings will be taxed and penalized if before 59½. The basic advice is, don’t; if you do, be sure it’s absolutely necessary and you’re thoroughly versed in exceptions and penalties for your individual situation.
RMDs or withdrawals from traditional retirement accounts can also increase your Medicare premiums by increasing your taxable income, so be sure to factor this into any withdrawal decisions between 65 and 72.
The mandatory age to begin withdrawals was 70½ until the SECURE Act increased that to 72 (70½ if you were 70½ before Jan.1, 2020).
The amount you must withdraw is based on your age and the account value on the last day of the previous year (so, Dec. 31, 2020, for withdrawals in 2021).
Usually, your investment house will calculate the amount for you or there are numerous calculators on the web.
Calculating and Making RMDs
If you have multiple retirement accounts, each RMD will be calculated based on the value of that account. But you do not need to make RMDs from each account, although you’ll probably get some nagging notices from each one. You can aggregate the amount and withdraw from one account only. This may be convenient if you intend to withdraw the RMD as shares rather than in cash.
You do not need to take RMDs in cash. If you like the investment and believe it has upside potential, or just don’t need the cash, you can transfer shares in-kind. This requires a bit of notice to your custodian or investment house, and it’s not possible to know exactly the value of the stock on the day of transfer, so don’t wait until late December to start the process! You’ll need to get as close as possible, or make up the difference in cash, or take a slightly larger than necessary distribution. You can choose to distribute shares from one account (or more) and make up the difference in the required amount from another account.
If you transfer shares, you’ll still owe taxes on the amount. It also resets the cost basis to the value at transfer, and the short term/long term gain determination begins with date of transfer. For traditional IRAs, it doesn’t really matter if you have a loss or gain in the shares before transfer — you still have to meet the RMD distribution. But for distributions from Roths, which are not required, you might want to pick appreciated shares since you’ll restart with a higher cost basis and the chance for lower capital gains when you sell.
If you do have multiple retirement accounts, you’ll make life much easier if you consolidate them, insofar as legally possible, into one or few accounts. You should choose what to sell or transfer based upon how the amount will affect your portfolio balance. You should consider your RMD when you rebalance your accounts, earmarking enough to distribute but still maintain your asset balance and provide cash spending needs. You can choose assets that are up, assets (especially individual stocks) that you’ve lost faith in and want to divest, or, per-haps easiest of all, shares in a balanced or target retirement fund.
Remember, there’s no obligation actually to spend the RMD: You just lose your tax-sheltered status for that amount. It’s not unusual for retirees to find that their RMDs exceed their need for spending funds. In that case, the RMD can go directly into your taxable brokerage account.
RMDs were not required of anyone for 2020. The stated rationale was that the market was quite high in December 2019, followed by a severe drop in the early part of the year. Therefore, RMDs would have been calculated on a higher value than portfolios were worth for part of the subsequent year. As of this writing, that pause has not been extended for 2021. If you think it might and you’re able to wait, you might want to wait until mid-2021 before taking the distribution. My crystal ball says this would primarily benefit people wealthy enough to have significant retirement accounts, so perhaps not the direction the Biden administration will take. If you don’t need funds immediately, wait and see.
Inherited IRAs, whether Roth or traditional, must be kept in a separate beneficiary account. They cannot be combined with your own retirement accounts. The calculated RMD is separate and in addition to any RMDs from your own retirement accounts. Contrary to the rules that apply to Roth IRAs you’ve established for yourself, inherited Roth IRAs do have minimum distribution requirements. But what those requirements are depend on when you inherited the account.
Inherited Before 2020
You were required to begin withdrawals no later than the year following the owner’s death. You can take distributions over your lifetime. If you are much younger than the original owner, this can be a very long time indeed, and the required RMD may be quite small each year. In addition, stretching withdrawals over a (second) lifetime gives you a very long time to let the account continue to grow. Well invested, it’s not unusual to take RMDs for many years yet still have close to the original value in the account.
While you must take withdrawals from both traditional and Roth inherited IRAs, the withdrawals from the Roth are not taxable. RMDs from a traditional inherited IRA are taxable as ordinary income.
Inherited in 2020 or Thereafter
Very large IRAs represented a huge delay on the government ever getting its money. As of Jan. 1, 2020, the SECURE Act sped up that process. If you inherited either a traditional IRA or a Roth, you now must clean out the account within 10 years. There are no specific required minimum distributions for any of those years: you can withdraw it all in the first year, the 10th year or different (or same) amounts every year. But withdrawals from traditional IRAs are fully taxable as income, so it’s worth considering the withdrawal and how it will affect your tax bracket.
Let’s say you inherit a $1 million traditional IRA. Withdrawing over 10 years might mean you’ll be kicked into a higher tax bracket, which will affect the marginal tax rate on your earnings, as well. The sudden rise in income can also affect family eligibility for college financial aid.
On the other hand, if you leave the $1 million to accumulate for 10 years, it can possibly have doubled. That means in year 10 you’ll be paying 37% income tax on twice as much — let’s say $740,000 on $2 million. On the other hand, if you’d withdrawn the entire amount in year 1, you’d have paid $370,000. Invested, capital gains would have been 15% or 20%, only when realized. If you are close to retirement yourself, or expect a significant drop in income sometime in the next 10 years, you may want to use lower income years to make withdrawals, to avoid increasing your tax bracket on your earned income.
If you inherited a Roth IRA, you might be tempted to cash it all in immediately upon receipt, since there’s no tax. If you do that, however, you’ve just given up potentially 10 years of tax-free growth. The larger the balance, the more that matters.
Of course, there are always exceptions.
According to Marketwatch:
“The rule does not apply to spousal beneficiaries, as well as disabled beneficiaries and those who are not more than 10 years younger than the account holder (such as a slightly younger sibling, for example). Minor children are also exempt, but only until they reach majority age. After that, they will have 10 years to withdraw the assets in an inherited account. Spouses, disabled beneficiaries and others under the exception will still be allowed to take distributions over their life expectancies.”
After a lifetime habit of saving and conserving our investments, it can be really hard to begin the withdrawal process. But this is what you’ve been trying to achieve: a funded retirement. You were wise enough to make tax-savvy investments. Now it’s time to reap the benefits, rendering to Caesar what Caesar has patiently been awaiting.
This article was originally published in the April 2021 issue of BetterInvesting Magazine.
Danielle L. Schultz, CFP, CDFA, is a fee-only financial adviser with Haven Financial Solutions, Inc., based in Evanston, Illinois. She can be reached at www.HavenFinancialSolutions.com.