You’re listening to uncommon sense, a podcast by Bowman Financial Strategies. I’m your host, Erik Bowman, and thank you for joining me today. Hi everyone and thank you for joining me today. This is Erik Bowman, owner of Bowman Financial Strategies. Our topic today is required minimum distributions or more commonly known as RMDs.
To some of you, it may come as a shock that you cannot keep your retirement funds in your retirement account indefinitely. Generally speaking, you really must start taking withdrawals from your IRA, your simple IRA or your SEP IRA or even your qualified retirement plans such as a 401k or 403B when you reach 70 and a half. Roth IRAs by contrast do not require withdrawals until after the death of the owner. Your required minimum distribution or RMD is the minimum amount of taxable distribution that you must take out of your retirement account each year. Once you reach 70 and a half.
The RMD poses all sorts of conundrums for retirees, like how is it calculated? Who calculates it, when is it due? What happens if I don’t take it and what if I don’t want to take it? And the list goes on. Today I’m going to cover the basics of an RMD. Who does it apply to? Calculations and resources to further educate yourself and of course some potential strategies that may alleviate some of the challenges surrounding RMDs, namely taxes.
So let’s start from the beginning. When you turn 70 and a half, you are required to take an RMD from your retirement account, an IRA, for example, by April 1st of the following year. For all subsequent years, you must take the distribution by December 31st of that year. For example, if you turn 70 and a half in August of 2020 you must make your distribution by April 1st of 2021. If you choose to do that, you would also have to calculate your 2021 RMD and also take that in 2021. So in actuality, in the first year that you decided to take that RMD, you would actually have to take two distributions. Now you don’t have to delay until April 1st you can take your RMD in the year that you turn 70 and a half.
An exception to this rule applies to 401ks, also known as a qualified retirement plan, which is the terminology that’s used to describe an employer sponsored 401k, 403B, 401A, just to name a few. For these accounts, you must take an RMD by April 1st of the year following the year you turn 70 and a half or upon retirement, whichever is later. If you’re still gainfully employed for example, and you have an act of 401k and you’re 72 years old, you don’t have to take an RMD from that qualified plan that you have at that current employer, even though you’re older than 70 and a half. However, once you retire, those RMDs are due by April 1st following the year that you retire. And one really big caveat and a mistake that you do not want to make that is even if you are working and you’re older than 70 and a half, if you have an IRA in addition to your 401k, you still must take your required minimum distribution from that IRA. Don’t make that mistake and I’m going to be talking about the penalties the IRS can impose if you fail to take your RMDs.
here are a few other points that may save you some headaches and money in the future. If you have multiple qualified plans or multiple 401k’s, meaning maybe you’ve worked at previous employers and you have simply left your money behind at those various employers 401ks and you have not moved them into IRAs, you must calculate the RMD for each account individually and then take the distribution from each of those respective 401ks by the deadlines. By contrast though, if you have an IRA or multiple IRAs, you can calculate the required minimum distribution for each IRA individually. Add those together and take the total sum of those as a distribution from one of your IRAs. Now, depending on how you’re investing your assets, this may be a beneficial thing to do. It certainly seems a little bit simpler than making a distribution from multiple IRAs. Since 403B’s are considered qualified plans, you might think that the same rule applies.
However, it is a little bit different. If you have more than one 403B tax, sheltered annuity account, also known as a TSA, you can total the RMDs from each of those 403Bs and then take them from any one or more of the tax sheltered annuities. So I mentioned penalties a little bit earlier. So let’s gather round and chat about this one. Most people are aware that if you take money out of an IRA before 59 and a half, that you will pay a 10% penalty on that distribution in addition to the taxes. And that’s not fun and should be avoided in most cases. By comparison, if you fail to take your RMD on time, you will pay a whopping 50% penalty to the IRS. Yes, that’s a 5- 0% penalty. So if you were supposed to take $10,000 out and you failed to do that, by the respect of deadline, you would literally owe a $5,000 penalty to the IRS in addition to income tax on the total amount. The IRS wants their taxes and they will get them one way or another. So don’t let this rule catch you by surprise.
So let’s talk a little bit about the actual distributions themselves. You actually do have a couple of options. First, if you’ve calculated your RMD for the current year, you can actually opt to take the full calculated amount in one lump sum anytime up until December 31st of that year. The one exception, of course, is your first year of required minimum distributions. You do have until April 1st of the following year, but that is only for year one. Another option is you may also choose to take periodic distributions over the course of the year to meet your obligation. You also want to take into account income, cash flow and expenses to help guide you here. But there could be strategic and tactical reasons why you might want to spread that out on a monthly or quarterly basis over the course of that year as opposed to making one large lump sum distribution. It’s a little synonymous with the concept of dollar cost averaging when you’re buying into stocks and bonds and other investments that you get a better average share price potentially by buying in over time. Same on the way out when you’re making distributions from your IRA. It could be beneficial to take smaller amounts out over a 12 month period and in that case in, if there was a declining market, you may have actually saved yourself some principle over time.
Okay, now onto calculations. How do we determine how much you must withdraw each year? No surprise here. It’s not the same every year. It’s kind of complex and it totally depends on your unique situation. The IRS publishes a table called the uniform lifetime table. It’s table three on the IRA RMD distribution worksheet that’s available on our website on this podcast page. For example, your first IRA distribution for the year you turn 70 and a half, requires you to know your exact balance of your IRA or IRAs on December 31st of the prior year. You then take this balance and divided by 27.4. Seems like an odd number but it’s a joint life expectancy number. So by dividing that balance by 27.4 the answer to that equation is the exact amount you must make as required minimum distribution. You need to do this for every single retirement account you have unless one of the exceptions I mentioned or other exceptions that your financial professional mentions may apply to you.
In the next year, when you turn 71, you will take the prior year’s 1231 balance and divided by 26.5 and by the time you reach 114 yes, the table actually goes out to 115 and older, you will divide by 2.1. So 2.1 is the divisor for one 14 it drops down to 1.9 when you reach one 15 and stays there if you happen to live longer than that. But what you’ll notice is that each year that goes by, the lower number in this equation gets smaller and smaller, which means the amount of money you have to distribute from your account becomes a larger portion of that account every single year.
another exception that we see periodically, it’s not an everyday occurrence, but it could be your situation. So this is an exception to the rules on that table and that is if your spouse is the sole beneficiary of your IRA and he or she is more than 10 years younger than you in this case, the IRA utilizes another table for you to calculate your distribution. The IRS wants more money from you while you are alive so that when your IRA is left to your younger spouse, who by the way can usually take RMDs based on their age and spread that out over a longer period of time. Well, there’s going to be less money in that account to spread over a supposedly longer lifespan of your younger spouse. It’s just another way of the government saying, we would like to ensure that we get these tax dollars sooner than later, but don’t forget that it is a totally different calculation with a different bottom number on that fraction when you’re calculating your RMDs, if your spouse is more than 10 years younger than you. Now there are many, many other rules regarding RMDs. If you’re a 5% owner of a company for example, and you’re still working in that company and you have a 401k, you’re not allowed to continue to delay RMDs, passed 70 and a half. You actually still have to take them per the original rules, but just know that you really should be talking with your financial professional before you solidify any of your RMD calculations or distribution strategy.
So relating to strategies, the name of our company after all is Bowman Financial Strategies and we really try to look for opportunities to save our clients money, save them on taxes and just to be efficient when it comes to the distribution of their assets during the retirement stage of their life. So relating to strategies, one of the challenges to a moderately high net worth individual is that you may have a pretty substantial retirement account. When you turn 70 and a half, you’re going to be forced to take a large taxable distribution if that account has grown and you haven’t made any distributions up until then. So for example, if you have a $3 million IRA under current law, your distribution that’s required the year you turn 70 and a half is roughly $109,000. Imagine you began taking your social security benefits at age 64 because you wanted to get it while the getting was good, you are afraid it was going to run out.
And that’s a separate topic. So you don’t take any meaningful distributions from your IRA from age 64 to age 70 and a half. Now you find that not only is your social security payment forever reduced because you filed early, but now you’re forced taxation at 70 and a half, maybe significantly higher than it otherwise would’ve been. All this is to say that your social security filing strategy should include understanding how your retirement accounts will be impacted by RMDs and ultimately how much in taxes you may pay by appropriately timing your social security filing, potential Roth conversions and IRA distributions along with distributions from your non-qualified brokerage accounts and other income streams, you may be able to significantly lower your tax burden over the life of retirement.
Well, I’m afraid I only scratched the surface on RMDs and all of the moving parts and potential strategies. Suffice to say it is complex penalties can be onerous and there may be strategies available to you that could lower your taxes significantly under the right circumstances. If any of this information is compelling to you and you want to learn more, I would love to hear from you. You can email me at E R I K @bowmanfinancialstrategies.com. That’s E R I K @bowmanfinancialstrategies.com. You can call our office at (303) 222-8034 and just simply schedule an appointment to come on in, have a cup of coffee and allow us to perform some analysis for you. Thanks so much for your time and I hope you have a great day. Thank you for joining me for Uncommon Cents, the Bowman Financial Strategies financial education series. I’d love to hear your feedback on financial topics you would like to learn more about. Just drop me an email at Erik, that’s E R I K @bowmanfinancialstrategies.com or go to the Bowman Financial Strategies website and send me a note on our contact page. In addition, you can always search for topics of interest in my archive on our podcast page at www.bowmanfinancialstrategies.com/podcasts. Have a great day.
This communication does not constitute federal tax advice and may not be used as such. Please consult a qualified tax professional for tax advice or assistance. In addition, investment advisory services offered by ChangePath LLC, a registered investment advisor, Change Path and Bowman Financial Strategies are unaffiliated entities.