There’s a reason why 401(k) and Individual Retirement Accounts are called “tax deferred.” US taxpayers pay no taxes on money contributed or income earned in the 401(k) or IRA until such is distributed. The IRS ultimately gets to tax you when withdraws are made. To make sure the payment of taxes happens, the Required Minimum Distribution (RMD) rules states when you have to start taking your RMDs or be subject to a penalty.
RMDs must be taken from IRAs starting in the year you turn 70.5 — and from 401(k)s at the same age, unless you’re still working for the employer that sponsors the plan.
RMDs are a double hit. First, the government requires you to pull money out of your accounts when you may not necessarily want to. Failure to take the correct distribution results in an onerous 50 percent tax penalty — plus interest — on any required withdrawals you fail to take. Second, you are taxed on the distribution.
RMDs can boost other expenses, too. Since distributions count as ordinary income, they can push you into a higher income tax bracket. RMDs also can trigger higher taxes on Social Security benefits and substantial high-income surcharges on Medicare premiums.
RMDs are calculated for each account you own by dividing the prior Dec. 31 balance with a life expectancy factor that you can find in IRS Publication 590. RMDs must be taken by year-end, subject to one exception. If you turn 70.5 in 2016, you have until next April 1, 2017 to take your 2016 RMD. However, doing that means you’ll be taking two distributions in 2017, your RMD for 2016 and your RMD for 2017.
Although RMDs are calculated for each IRA you own, you don’t have to take a separate distribution from each account. You could total up all your IRA RMDs and take it all from just one IRA. With 401(k)s or other workplace plans, the RMD must be taken from each individual account you own.
If you’ve left a trail of 401(k)s at various jobs over the years, that can be a chore and a good argument for consolidation. If you’re just getting into the world of RMDs, it’s a good time to consolidate your 401(k)s and IRAs by minimizing the number of accounts you have, so you can keep track of them more easily.
If you’re over age 70.5, your option for minimizing your RMDs is basically one. You can convert your IRAs into a Roth IRA. You’ll owe income tax on the money you switch into the Roth account in the year of the conversion, but you won’t need to take RMDs in future years. Plus, qualified distributions from the Roth IRA are income tax free.
It is important to remember the RMD rules kick in when you turn 70.5. If you turned 70.5 in 2015, you still have until April 1, 2016 to take your 2015 RMD. If you turned 70.5 in 2016, you can take your first RMD in 2016 or by April 1, 2017 for the 2016 tax year. Whatever your decision, not taking your required RMDs can result in a substantial penalty, additional taxes and interest. All of which can make you a very unhappy camper.
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