Friday, July 18, 2014

Wanna Pay a 50% Penalty on Your Retirement Account?

There are some things to know about your retirement accounts that are incredibly important, not the least of which is that the IRS can force you to pay a penalty of 50% in addition to any taxes you owe if you screw up required minimum distributions (RMDs) from certain types of those retirement accounts.

(If this is way more than you want to know about IRA's, please skip ahead to the last two paragraphs. If you don't even have a retirement account other than a Roth IRA and don't expect to, maybe just check out 10 Supplies You Always Need at the Gym over at Buzzfeed.)

According to the IRS website,
"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."
(So, you get a break from the IRS if you're dead. Good to know.)

A 50% penalty. Surely that got your attention.

There are basically two individual retirement account deals offered by the IRS: a traditional IRA and a Roth IRA.

The IRS offers a tax deduction when you contribute funds to a traditional IRA. You contribute "pre-tax" dollars. Because Congress didn't want wealthy people to be able to avoid taxation on those funds forever, they mandated required minimum distributions (RMDs). The effect of RMDs is that after age 70½, retirees must withdraw at least a certain percentage of their current traditional IRA balances and pay taxes on those withdrawals.

That's the bad news   you'll have to pay taxes on your traditional IRA's when you withdraw and you will eventually have to make withdrawals. The worse news is that it will all be taxed as ordinary income, even if you earned the money with long-held stock investments. Preferred capital gains rates don't apply to holdings in an IRA.

Roth IRA's are the other, different deal. You don't get a tax deduction for contributions up front. You contribute after-tax dollars. The good news is that there are no taxable required distributions from individual Roth accounts (there are from Roth 401(k) accounts, though) and the contributions and any earnings on those contributions are never taxed.

Which is the better deal? That depends on whether your taxes are higher when you contribute or when you withdraw. And, that's fairly unpredictable.

The IRS enforces the RMD penalty if you don't withdraw the required minimum amount each year after age 70½. (The penalty may be waived if the account owner establishes that the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall.) You will not only have to pay taxes on the correct amount of the withdrawal you didn't make on time, you will have to pay a 50% penalty on the shortfall and you will still have to withdraw the funds from your IRA.

This is a costly mistake you don't want to make.

The calculations look complicated (see Form 5329), but there are calculators on the web to help, and your investment company may even offer a service for free to remind you and calculate your RMD for you. Vanguard offers such a service, for example, though you have to be 69½ to enroll.

The minimum amount to withdraw is based on your life expectancy as calculated by one of three tables provided by the IRS. (Here's an easier-to-read version from Forbes magazine than IRS Publication 590 provides.)

If you are 72, for instance, the uniform table calculates your life expectancy as 25.6 years and that year you must withdraw the total of your IRA Account balances divided by 25.6. That's about 3.9%. At age 82, that will grow to 5.85% of whatever you have left in those accounts.

Recently, I received a couple of questions regarding RMD's and sustainable withdrawal rates. The common thread of the queries was, "What do I do when the IRS requires that I make withdrawals that are larger than my 4% safe withdrawal rate? Won't I deplete my portfolio too fast?"

(RMDs exceed 4%, for example, after age 73.)

The first thing to realize is that they're two very different things. SWR withdrawals are spent while RMDs are only taxed. The assumption is that if you didn't need the entire 4% SWR withdrawal in a given year, you would leave what you didn't spend in your portfolio.

IRA RMD's are withdrawn so that you a) must pay taxes on them and b) you stop any future tax deferrals on the withdrawal amount. The IRS doesn't say you have to spend the withdrawal. Just reinvest the balance after taxes into a taxable account. Heck, put it into the same mutual fund you took it out of, if you like, just do it in a taxable account.

The second thing to be aware of is that safe withdrawal rates also increase with time. According to William Bengen's original work, "SAFEMAX" is about 4.4% when you have 30 years left in retirement, 5.2% with 20 years remaining and 8.9% with 10 years remaining. Other studies show similar results (with the caveat that I don't trust any of them.)

Lastly, we can't assume that all of a retiree's portfolio resides in traditional IRA accounts. If half the portfolio is in taxable accounts, for instance, and half is in IRA's, a 3.9% RMD from the IRA's would only equate to a 1.95% portfolio withdrawal.

So, required minimum distributions shouldn't destroy your retirement spending plan unless it was developed with the incorrect assumption that you would never have to pay taxes on any of your retirement accounts.

To sum it all up, it is very important that you understand that there are certain amounts of your traditional IRA's and similar retirement accounts that must be withdrawn and taxed after age 70½. The rules are complex and violating them can cost you a bundle in penalties.

If tax gibberish is just beyond your attention span (in other words, you are normal), then I suggest the following. Make a note to call your tax professional or your mutual fund customer service department on your 70th birthday and ask what you need to do about required minimum distributions or "RMDs". Or call that customer service department today and ask if they offer a reminder service.

A potential 50% penalty should be plenty of incentive.


  1. Hi Dirk,

    I never did open a Roth IRA; we only have traditional IRA(s). My reasoning is/was that I'd prefer to contribute before-tax dollars now, to provide a larger foundation for appreciation and to reduce my current income tax. Later, when I need to withdraw from the IRA, if my tax rate is low (because I don't have much other income) then, it is what it is. And if my tax rate then is high (because my taxable investments are throwing off all sorts of wealth) well, I won't care much because I'll be able to afford it!

    Anyway, the other observation about minimum withdrawals is that they are (as you pointed out) a percentage of the value of the account at the start of the year. So if you don't need more cash from the IRA then, by definition, it'll never run dry.

    I think IRAs are a wonderful thing.

  2. I'm very happy with my traditional IRA decision, as well. I got great tax deductions when I needed them. And I've been able to tax-efficiently convert much of the savings to Roths since i retired.

    I will point out though, that if you're taking increasing percentages of a dwindling account balance, never running dry will soon become a point of semantics, like that old story about the frog that covers half the distance to a well with each leap and never gets there. Calculus works that way; real life, not so much.

    Thanks for writing!

  3. I appreciate Mr. Gray's admiration of traditional IRA's, but if you're like me and have a pension (a rarity, I know, but the Feds still offer them to employees), having a bunch of traditional IRA's at the time you hit 70.5 can be a real tax burden. I know this isn't so much a problem as it is what might better be called an "issue," but there it is.

    I'm in the process of transferring over as much of my traditional IRA and 401K accounts as possible each tax year by filling out my tax bracket annually with such transfers. When I hit 70.5 in 5y (Allah, God, or Ganesh, whomever, willing), I don't want to be in the same situation as a colleague of mine who's paying huge tax bills on funds that she doesn't need at this stage of her retirement.

  4. I'm doing the same with my IRA's. In fairness, though, you can't look at one end of the transaction and call it a burden. Neither of us knows, given the information you provide, whether she would have been better off paying taxes at the time she made those contributions than she is paying taxes now. During my peak earning years, the tax deferrals were pretty sweet, and I've had decades to work on the tax problem of withdrawals.

    1. Indeed, you're correct that she has not done the math to determine which, ultimately, was "better." When she and I set up these IRA's, however, the selling point was that you were more likely to have a lower income and, thereby, lower taxes at the time of withdrawal. Didn't happen. Another instance of "truthiness," to expand on our former President's vocabulary. It's a minor issue for both her and me, and thank heavens we both have some time to do the transfers (me more than her, and my wife more still). Something to be aware of if you retire with "enough," though.

    2. I don't believe that "didn't happen" is a fair general assessment. I've been retired for ten years, for example, and my taxes have been far lower than when I contributed to an IRA.

  5. Thanks so much for this post. You’ve shared so much insight and information that is greatly appreciated.

  6. Hi Dirk, one thing I think would be interesting is to see SWR in combination with different asset allocations. I would assume the SWR might increase with less volatility (lower stock allocations) up to a point where you don't have enough in stocks to have enough growth for a given SWR. Brad

  7. Brad, as you are probably aware, I believe SWR studies have major flaws and I take them with a grain of salt. I don't believe our limited historical stock returns data is adequate to predict future withdrawal rates, Pfau, et. al., believe future SWR's will be significantly lower than in the past, the SWR rates calculated only worked in the US market and, to quote Pfau, may well be an anomaly of U.S. history, and that's only the start.

    Having said that, Bengen's book, Conserving Client Portfolios During Retirement, deals extensively with portfolio allocations. In general, SWR's plateau for 30-year retirements between 45% and 60% stocks and drop off significantly at both ends.

    In your terms, SWR increases as you add stock up to about 45%, flattens out until you reach about 60% stocks, and then declines.