Understanding Required Minimum Distributions of IRAs

We’ve always been told that knowledge is power, but when it comes to the required minimum distributions (RMD) on your IRA, knowledge also equals money. Why? Because many people don’t realize they are required to withdraw a minimum dollar amount from their IRA starting at the age of 70 ½. Additionally, these individuals may not be aware that they will be required to pay taxes on that distribution, i.e. the money that they take out of their IRA.

The fine print of IRA distributions

The required minimum distribution transaction applies to an IRA, a SEP IRA or a SIMPLE IRA, as well as any retirement plan account, according to IRS.gov. The exception is a Roth IRA, which doesn’t require withdrawals until the death of the owner.

Withdrawing the RMD isn’t a complicated matter, but you can incur some hefty penalties if you fail to do it properly. To start with, you or your financial advisor will need to calculate the correct amount that should be taken out each year. This is done by taking the December 31 prior year balance of your account and dividing it by the IRS’s life expectancy factor published in in Tables in Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs). The table that you select will be based on your specific situation.

You have the option of withdrawing more than this amount, as well. Remember, there are penalties if you fail to withdraw the correct amount. The RMD amount that should have been removed will be taxed at a rate of 50 percent. If you were supposed to withdraw $10,000, your penalty would be $5,000.

Taxing IRA or retirement plan distributions

One of the major advantages of an IRA or retirement plan is that any money you put in it is invested as pre-tax or tax deferred. Once you do withdraw that money to use in retirement, you are then responsible for taxes on that amount because it is perceived as income.

The amount of taxes you will owe on your RMD is based on your normal tax bracket. RMD can also affect your Social Security. Any RMD funds should be calculated as part of your normal income to determine your Social Security thresholds—whether 50 or 85 percent of your benefits will be taxable.

Consider a Roth IRA

As mentioned above, a Roth IRA does not require the investor to make annual minimum withdrawals. Converting your existing IRA or retirement plan to a Roth IRA is something you should discuss with your financial advisor. You will be taxed on the money when it is transferred to the Roth IRA, but once you start taking distributions it will then be tax-free.