Lasting Situations of Wealth

When Congress first began writing legislation for tax-favored retirement plans in the 1970s, some of the provisions were likely based more on projections (guesses) than historical precedent or experience. This seems particularly true of the required minimum distribution (RMD) regulations which mandate that a certain percentage of retirement account accumulations must be withdrawn after the account holder reaches age 70½ (unless, in the case of an employer plan, a rank-and-file employee continues to work after that age).

As qualified retirement accounts, IRAs, SEPs, 401(k)s and the like were specifically intended to provide retirement income. And considering the tax-deferral features on deposits and accumulations, the Federal government certainly has an ongoing interest in eventually “recovering” these tax-deferrals during distribution. But why age 70½? As life expectancy continues to increase and general good health extends later in life, many qualified retirement account holders age 70½ or older may still be working, and/or may not want or need to take distributions from their accounts. For these individuals, liquidation from a retirement account will result in additional taxable income, and the funding of a new, non-qualified accumulation vehicle. Both facets of this distribution process could benefit from some forethought and planning.

The first issue to address in required mandatory distributions is the resulting taxable event. The entire distribution from qualified retirement plans (except amount attributable to after-tax contributions) is treated as taxable – there is no distinction between principal and earnings. As such, this additional income, whether spent or not, is taxed at the individual’s highest marginal tax rate. For individuals who are currently receiving income from other sources (wages, passive income, dividends, etc.), this means distributions from qualified plans may actually end up being taxed at a rate greater than the tax-deferral that was received when the money was deposited. While the taxability of qualified plan distributions is unavoidable, some individuals may want to consider ways to either offset the current taxation, or minimize the impact of future taxes on the distributed funds. For example…

Suppose a $24,000 RMD is required. This means an additional $24,000 must be reported as income. When making a required mandatory distribution that is not intended to be spent, the individual has to find a new place to hold and/or invest the $24,000 (or $24,000 minus the taxes due). Where should the money go?

If the retirement account had been invested in a financial product that delivered good returns over the years, the individual might choose to place the money in a similar product with non-qualified status. But depending on the type of account and the assets held in it, the new account may be subject to taxes on interest earnings, dividends, and short- and long-term capital gains. These annual taxes create an ongoing, compounding opportunity cost for holding the investment. Especially if these assets are intended to be held long-term, and perhaps intended to be part of an inheritance, the compounding opportunity costs may make the non-qualified version of this financial vehicle less attractive.

On the other hand, there are some financial transactions that have tax advantages. If the distribution were used to make mortgage payments on a second home or investment property, some of the reportable income from the distribution might be offset by a deduction for the interest portion of the mortgage payments. Using the $24,000 cited above to make a mortgage payment of $2,000 each month might not only reduce the tax on the distribution, but also secure a nice piece of real estate.

If these distributed-but-not-spent retirement account assets are earmarked to be part of an inheritance or estate plan, the annual distributions could be used to fund a tax-deferred annuity or buy life insurance. These insurance products have tax advantages and contractual guarantees that many people find valuable in ensuring a legacy for heirs.

HAVE YOU CONSIDERED A PLAN FOR YOUR DISTRIBUTIONS?

Selected FAQs about RMDs from the IRS

The Internal Revenue Service website (www.irs.gov) has an extensive listing of the regulations for Required Minimum Distributions, as well as additional publications available for download. A brief reading of these regulations - and the penalties for improper distributions – should prompt you to seek expert assistance. Here are a few Frequently Asked Questions regarding RMDs, direct from the IRS:

What types of retirement plans require minimum distributions?

The RMD rules apply to all employer sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs. The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive.

When is the deadline for receiving a RMD from an IRA?

An account owner must take the first RMD for the year in which he or she turns 70½. However, the first RMD payment can be delayed until April 1st of the year following the year in which he or she turns 70½. For all subsequent years, including the year in which the first RMD was paid by April 1st, the account owner must take the RMD by December 31st of the year.

How is the amount of the RMD calculated?

Generally, a RMD is calculated for each account by dividing the prior December 31st balance of that IRA or retirement plan account by a life expectancy factor that IRS publishes in Tables in Publication 590, Individual Retirement Arrangements (IRAs). There are three separate tables:

• The Joint and Last Survivor Table is used by an account owner whose sole beneficiary of the account is his or her spouse and is more than 10 years younger than the account owner;
• The Uniform Lifetime Table is used by account owners who are unmarried or whose spouse is not the sole beneficiary or whose spouse is not more than 10 years younger; and
• The Single Life Expectancy Table is used by a beneficiary of an account.

Can an account owner just take a RMD from one account instead of separately from each account?

An IRA owner, after calculating the total amount s/he needs to take from the aggregate balances in his/her IRAs, can take that amount in any portions s/he chooses, from any one or more of the accounts.  However, RMDs required from other types of retirement plans, such as 401(k), 403(b) and 457(b) plans, have to be taken separately from each account (e.g., if a person has one 401(k) plan which is twice as large as another 401(k) plan, the RMD for the first will be twice that of the second, and if s/he takes less than the required amount from the first, s/he cannot “make up for it” by taking more from the second.

What happens if a person does not take a RMD by the required deadline?

If an account owner fails to withdraw a RMD, fails to withdraw the full amount of the RMD, or fails to withdraw the RMD by the applicable deadline, the amount not withdrawn is taxed at 50%. The account owner should file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with his or her federal tax return for the year in which the full amount of the RMD was not taken.