Understanding RMDs: A Q&A for Efficient Tax Management
Learn how to manage Required Minimum Distributions to maximize your tax savings
As the dust settles on the 2022 tax season, now is the perfect time to plan ahead for your future tax strategy, especially if you’re nearing retirement age or have pre-tax retirement accounts. A critical aspect of this planning involves understanding the rules and strategies around Required Minimum Distributions (RMDs). From when they must be initiated to the penalties for missing them, understanding the ins and outs of RMDs can significantly impact your retirement strategy and overall tax situation. To aid in understanding and planning for this topic, we have curated a comprehensive Q&A style guide, addressing their purpose, regulations and potential tax-saving strategies to ensure you’re managing them as efficiently as possible.
Q: What are required minimum distributions?
A: RMDs are required distributions taxpayers must make from certain retirement accounts containing contributions not yet subject to income tax. These RMD rules apply to all employer-sponsored retirement plans, including profit-sharing plans, 401(k), 403(b) and 457(b) plans. They also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs. Money is contributed into these accounts on a pre-tax basis, usually from payroll deductions, and allowed to grow without being reported on the owner’s tax return as income. Only when the owner withdraws these funds are they subject to income tax on their personal tax return.
Q: Are Roth IRAs also subject to RMD rules?
A: No, Roth IRAs differ from other retirement accounts because they are funded with after-tax contributions. Since Roth contributions have already been taxed, there are no RMDs required. You can withdraw your money tax-free if you are over 59 ½ years old and have had the account open for more than five years. For those who have several years before they retire, Roth IRAs can be used in retirement tax planning by rolling over some of your retirement account dollars into these Roth IRAs. You will have to pay taxes on any rollover amounts in the year they are rolled over, but this can be managed to fit into your tax plans each year and result in a lower amount of retirement income subject to RMDs in the future.
Q: When must RMDs begin?
A: Beginning in 2023, RMDs must be taken in the year the taxpayer turns 73 years old. From this point on, the taxpayer must take RMDs annually. Your initial distribution can be delayed until April 1 of the following year but, afterward, must be made by December 31 for each subsequent year. This means a taxpayer who turns 73 in 2023 must make their first RMD by April 1, 2024, and their second RMD will be due by December 31, 2024. Each year afterward, their RMD will be due by December 31.
Q: How are RMDs calculated?
A: A separate RMD amount is calculated for each account based on the balance on December 31 of the previous year and dividing by the current life expectancy based on the IRS tables. RMD amounts may be calculated by the retirement plan administrator or IRA custodian, but the responsibility falls on the account owner to take and report the correct RMD amount to the IRS.
Owners of multiple IRA accounts will need to be organized with their information because each account requires its own RMD calculation. Once the total RMD amount is known, the taxpayer can withdraw the annual RMD amount from any number of their IRAs. Taxpayers are not required to take distributions from each IRA as long as the total required amount is paid. However, this is not the case with other retirement plans such as 401(k) and 457(b). These types of accounts must each have separate distributions made from each account. Of course, the IRS will always allow you to withdraw more than the RMD amount if you choose, but this will not reduce the RMD amount for future years.
Q: What is the penalty if an RMD is not made by the deadline?
A: Previously, if a taxpayer failed to withdraw the correct amount by the due date each year, they were subject to an additional 50% excise tax on any remaining RMD amount. Thanks to the recent SECURE Act 2.0, this penalty has been reduced to 25% with a “correction period” that further reduces the penalty to 10% if the taxpayer corrects the error within two years following the year the RMD was due.
Penalty amounts are calculated on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
You can also request the penalty be waived if you can show the underpayment was due to a reasonable error and reasonable steps have been taken to correct the issue. To qualify for a waiver of the RMD penalty, the taxpayer must attach a letter of explanation to their Form 5329.
Q: Can you suggest any tax-saving techniques for taxpayers who have RMDs?
A: There are a few options available to taxpayers regarding RMDs. For those still working and enrolled in a workplace retirement plan such as a 401(k) or profit-sharing plan, you can choose to keep working. Account owners can delay taking RMDs from their workplace plan if they are still working and do not own 5% or more of the company, but this does not apply to traditional IRAs.
Another strategy is to avoid delaying the first RMD payment. Even though delaying your first RMD payment to April of the following year is allowed, it isn’t necessarily a good idea from a tax planning perspective. If you choose to delay the first RMD after turning 73 to the following year, you will still have your next RMD due on December 31 of the same year. This means you will pay taxes on two years’ worth of RMDs in one year, which might bump you into a higher tax bracket.
One of the most frequently used RMD strategies is to make qualified charitable distributions (QCDs). This involves directly distributing funds from your traditional IRA to a qualified charity. They are limited to $100,000 per year and must be made to an IRS-qualified charity. The account owner would choose a charitable cause they care about and donate their RMD up to the $100,000 limit. The IRA administrator would distribute the amount directly to the charity, and the taxpayer would not have to pay individual income tax on the distribution amount.
This offers better tax savings regardless of whether you itemize since the QCD amount is not included in taxable income rather than a tax deduction. QCDs only apply to IRAs and not 401(k)s or other employer-provided retirement accounts and cannot be made to donor-advised funds. While this strategy is often used for RMDs, taxpayers can begin making QCDs at age 70 1/2.
Retirement brings new opportunities but also requires tax planning and navigation to get the most out of your retirement savings accounts. Contact an Adams Brown advisor to help you plan for this important time of life and help make the best decisions to get you to your retirement goals.