Thursday, October 24, 2019

Two Pitfalls at Age 70½ That You'll Want to Avoid: Missed RMDs and the Tax Torpedo

It seems like hardly a week goes by without someone emailing me to ask, "who is the pinko-Commie wealth-confiscator who created RMDs and why do I have to disturb my nest egg and pay taxes on it?" or something to that effect. With my contemporaries approaching the key age of 70½ (well, more accurately the contemporaries of my imaginary much older sister), maybe it's time for one more post on required minimum distributions (RMDs).

In case you bail on this post after a couple of paragraphs, there are two very important things to know before you go. First, you are required to pay required minimum distributions on all employer-sponsored retirement plans, including:
  • profit-sharing plans,
  • 401(k) plans,
  • Roth 401(k) plans,[1]
  • 403(b) plans,
  • 457(b) plans, and
the RMD rules also apply to traditional IRAs and IRA-based plans,  including
  • traditional Individual Retirement Accounts (IRAs),
  • SEPs,
  • SARSEPs, and
The RMD rules do not apply to Roth IRAs while the owner is alive but may apply to an inherited Roth. The rules differ for a spouse and other beneficiaries.[10]

If you have one or more of these accounts, heads up!

Second, the penalty for missing an RMD due date or withdrawing less than the correct RMD is 50% of the amount not withdrawn by the due date.[11] Your read that correctly — 50%.  Your first RMD will be due by April 1st of the year after you reach age 70½. After that, RMDs are due on December 31st every year. Kiplinger has a calculator if you want to double-check your calendar math.[2]

OK, having been suitably warned, you can now feel free to bail at your own risk.

Congress created the IRA in 1974 with a pretty simple deal. Eligible workers under the age of 70½ could contribute to an IRA annually the lesser of $1,500 (a little over $7,000 in today's dollars) or 15% of compensation and not pay income taxes on these contributions or their investment earnings until funds were withdrawn from the IRA when we retired, which, at the time, seemed eons in the future.

Since withdrawals would be taxed at whatever the ordinary income tax rate (the rate we pay for work income) might be on the future date of the withdrawals, we were essentially allowed to defer income taxes on the amount of the contributions for four decades or so, at which time we would finally begin to pay income taxes on the original income and any earnings on that income. (The taxes were deferred, not avoided.)

This sounded like a pretty good deal and a lot of people jumped at it. Contributions totaled $1.4B in the first year. It was a good deal but after 44 years of tax deferral, shock of shocks, a lot of people don't want to pay the taxes now, either!

Go figure.

By 1987, Congress apparently realized that wealthier households might not need to spend the money in their IRAs so they created RMDs to discourage taxes being deferred forever. The goal of RMDs is to help ensure that most retirement account savings are actually spent during retirement, which was the original intent of Congress.

As I mentioned, the penalty can result from missing a deadline but also from miscalculating the RMD and withdrawing too little even if the deadline is met.

RMDs are calculated by dividing the balance of your IRA account on December 31st of the previous year by a factor that is based on your current age from IRS tables.[4] This is definitely the hard way.

You can Google a plethora of RMD calculators on the web that will make the calculations simpler. Your account custodian's[12] website probably has one. You will need to calculate the RMD for all retirement plans except Roth IRAs held with all custodians and withdraw their sum.

Easier still is to sign up for automatic RMD services with the investment companies that act as custodians for your accounts. Vanguard[8], Fidelity[7] and Charles Schwab[9], for instance, offer these services. They will withdraw the correct RMD by the correct deadline and eliminate that source of stress.

If you do make an error, Kiplinger explains that the error can be fixed and the penalty waived under certain circumstances.[3]

The second potential pitfall that can occur at age 70½ is directly related to RMDs but involves the taxation of your Social Security benefits. Social Security benefits are taxable at one of three levels based on your "combined income", which is essentially half of your Social Security benefit plus your other gross income and any tax-exempt interest.[5]

Based on this combined income, either none, 50% or 85% of your Social Security retirement benefits will be taxable. The 70½ problem is that RMDs might increase your income enough to make more of your Social Security benefits taxable, thereby increasing your total tax bill. This is a possibility, sometimes referred to as the "Tax Torpedo", that you should discuss with your tax planner, preferably well before you reach age 70½.

I receive a wide range of questions regarding RMDs and many are not what I would have expected. Here are a few of the more common queries:

I don't need to spend the RMDs I will withdraw. What am I supposed to do with the money?

This is one of those unexpected questions that I receive a lot and I have settled on the following response. When RMDs are withdrawn, the IRS essentially turns part of your retirement account balance into income that is taxed at ordinary income rates like income from a job. I suggest you consider the withdrawal a paycheck — it's going to be taxed as if it were. You can even have taxes withheld.

What would you do with this "paycheck?" Anything you want, the same as any other paycheck, except for putting it back into a tax-deferred retirement account.

The IRS doesn't care what you do with the withdrawn funds so long as you pay taxes on the withdrawal and stop deferring taxes on this amount by withdrawing it from the tax-deferred retirement account. You can spend the money, transfer it to a checking or savings account, or reinvest this part of your nest egg in a taxable account. Some of the custodians of your accounts, Schwab for example, will allow you to automate any of these actions.

Bottom line, if you don't want to spend this part of your nest egg, reinvest the remainder after taxes in a taxable account.

If I reinvest these withdrawn funds in a taxable investment account, will I not be taxed twice on my retirement savings?

No, you are finally being taxed for the first time on your tax-deferred contributions, possibly made decades ago, and their earnings. If you reinvest the withdrawn funds in a taxable investment account, you will be taxed on any future earnings on that account but you won't be taxed again on your retirement account contributions or earnings.

Can RMDs be avoided or reduced?

Maybe, if you start tax planning early enough to do Roth conversions, for example. Roth conversions are taxable, too, but you may be able to convert at lower tax rates, possibly even zero. This is another issue you will need to discuss with your tax planner but the closer you get to age 70½, the less likely you will be able to reduce RMDs.

As we approach age 70½, it is important to be aware of pending required minimum distributions and to avoid penalties for late or miscalculated withdrawals. The stress-free way to achieve this is to automate the RMD process with your retirement account custodian. They can ensure that your RMDs are accurately calculated for the accounts they hold, that the withdrawals are made on time, and that the funds you withdraw are used as you prefer.

We also need to be aware of the Social Security taxation implications. This is a fairly complicated issue that most retirees should discuss with a qualified income tax professional rather than trying to navigate it on their own.

Here's a brief to-do list:

1. If your account custodian is not one of the three I mentioned, contact yours and find out if they can automate your RMDs.

2. The automated RMD services typically require that you be at least 70½ years of age to make the request. Calculate the dates that you and your spouse will reach age 70½ here and stick reminders in your smartphone calendar to set up automated RMDs with your custodian(s) on those dates. If you have passed this age already, you can start the service immediately.

3. Start discussions with your tax advisor well before age 70½ if you hope to reduce RMDs or plan for the Tax Torpedo.

You can find much more detail on all of these topics at the references listed below.


[1] Technically Roth 401(k)s, if they remain with your company after your departure or retirement, are subject to RMDs after age 70½. However, they can be rolled into a Roth IRA, which is not subject to RMDs during the owner's lifetime.

[2] When Do I Have to Take My First RMD?, Kiplinger

[3] Avoiding the 50% Penalty on Overlooked RMDs, Kiplinger.

[4] Required Minimum Distribution Worksheets | Internal Revenue Service

[5] How Worried Should I Be About the 'Tax Torpedo'?, Kiplinger.

[6] Benefits Planner | Income Taxes And Your Social Security Benefit | Social Security Administration

[7] Fidelity Investments Automatic Withdrawals - RMD

[8] Vanguard's Required Minimum Distribution Service

[9] Charles Schwab Automated RMD Service

[10] IRS Publication 590-B Cat. No. 66303U Distributions from Individual Retirement Arrangements (IRAs), page 35.

[11] A penalty will apply if your calculation is too low and you withdraw too little. Miscalculating and withdrawing an RMD that is too high won't generate a penalty because you can always distribute more than the minimum, though this may not be what you intend.

[12]  An IRA custodian is a financial institution that holds your account's investments for safekeeping and sees to it that all IRS and government regulations are adhered to at all times. Retirement Tips: How to Choose the Best IRA Custodian,