It's said that only two things in life are certain – death and taxes – and, in fact, the IRA minimum distribution rules touch on both of these issues. People are living longer, and the medical costs continue to rise, so retirement savings are ever more critical – but how might the amount you have put aside be affected by the IRA minimum distribution rules? Let's look at this in more detail.
Minimum distribution rules (also frequently referred to as required minimum distributions or RMDs) apply to all types of retirement savings accounts, but in different ways. Withdrawals almost identical with IRA minimum distribution rules are mandatory if you have a traditional 401k, or indeed any other retirement account with tax advantages, like a 403b, a 457b, or a traditional IRA. For these types of accounts, you'll need to start making withdrawals no later than the 1st of April in the year after you reach 70 1/2. However, the one diversion between IRA and employer plan distribution rules is that if you are still working for your employer come age 70 1/2, you may defer distributions until April 1 of the year after you retire. Note that this does not apply to those who own 5% or more of the company so it would not apply to most any keogh plan. (Here is a little-known tactic for using this rule and deferring the IRA minimum distribution).
These IRA minimum distribution rules also apply to Roth accounts, including both Roth 401k accounts and Roth IRAs, although they don't come into effect until the owner of the Roth IRA has passed away. Roth IRA withdrawals by the account owner are totally discretionary. Roth 401(k) accounts have the same mandatory distribution requirements as any other 401(k) account. However, most participants in a Roth 401(k) will simply roll over their balance to a Roth IRA, thereby eliminating the need to take minimum distributions during his lifetime. The non-spouse beneficiaries of a Roth IRA do need to comply with IRA minimum distribution requirements.
If you hold funds in traditional retirement accounts, required IRA minimum distribution rules call for using an IRS formula that takes into account your age, your life expectancy, and the balance of your accumulated retirement savings. Naturally these figures are likely to change, so your IRA minimum distribution is calculated annually to take account of these changes.
Through the application of the IRA distribution rules to traditional retirement accounts, the government receives some of the tax due on the money in these accounts. If these accounts weren't subject to any minimum IRA distribution requirement because the funds within them were accumulated without any deductions for tax, the individual could hold onto them during retirement so they don't have to pay any tax, and leave all the money as an inheritance. The reduction in the amount of tax revenue the government would most likely receive, due to retired individuals choosing not to make withdrawals from their investment savings accounts, is why IRA distribution rules exist.
However, minimum IRA distribution rules aren't entirely self-serving on the part of the government. They can also help to spread the tax burden due on funds saved in traditional retirement accounts out over time, to the advantage of the participant. Congress could insist that the entire balance be removed from IRAs at retiremet but it does not.
Take a look at these two different situations, and the effect they would have on the tax the individuals would need to pay. In the first, a recent retiree withdraws a large lump sum from his or her retirement savings account to provide for financial expenses over several years. If he does this, he will face a tax bill based on the whole amount he takes out of their retirement savings account, be forced into a higher tax bracket and pay a large amount of tax all at once.
Thanks to required IRA minimum distribution rules which smooth the payments over time (i.e. annually), participants in traditional retirement savings accounts can spread their withdrawals over the years, resulting in a much smaller financial burden come each tax time!
Lose a Fortune on Your 401k Rollover
If you do not do any of these correctly:
- Opt for a distribution rather than direct transfer
- Rollover company stock to an IRA
- Choose to rollover to a Roth IRA
- Rollover to your new employer’s 401k
- Rollover post-tax contributions