Financial Planning Focus – Managing Required Minimum Distributions to Maximize Benefits

August 01, 2016
By Dana G. Sippel, CFP®, CPA

Required Minimum Distributions (RMDs) are a frequently misunderstood, but critically important concept, relating to tax-deferred retirement portfolios. Investors approaching the age of 70 must understand how RMDs work so that they can successfully avoid steep IRS penalties, while minimizing income taxes.

If you have a tax-deferred retirement account, you should familiarize yourself with required minimum distribution rules.  Tax deferred retirement accounts, including IRAs, SEP IRAs, SIMPLE plans, 401(k)s, 403(b)s and TSPs, all require that distributions of the account balance begin at age 70 ½. While there are some exceptions to the RMD rules the general purpose of RMDs is to allow the IRS to begin collecting income taxes on accounts that have likely been growing tax deferred for decades.

The factors used to determine RMD amounts include end-of-year account balances, and life expectancy information available from IRS tables found online or in IRS publications. For example, the distribution factor at age 70 ½ equates to about 3.6% of the account value. If you have an account balance of $1 million at the end of the first year that you are required to take a distribution, then your distribution amount would be $36,000. You must recalculate the required distribution each year, using the age-based factor from the IRS table and the most current December 31st account  balance.

An investor who has multiple IRAs, whether to utilize varying investment strategies, provide creditor protection or to assign benefits to many beneficiaries, will need to consolidate balances to calculate the annual RMD. In the case of multiple IRAs, you may be able to take the RMD from any one or a combination of the IRAs to meet the RMD requirements. However, this may not apply to any qualified retirement plan balances in employer-sponsored plans. It is a good idea to check with the plan administrator to see whether the plan requires that you take a separate distribution, or if you can satisfy the RMD rules by taking the distribution from another retirement account.

Tax planning is a critical piece of managing your RMD. The most effective tax planning can begin as much as a decade ahead of reaching the age of 70 ½ and may involve taking taxable distributions from your IRAs prior to the required beginning date. These potentially lower tax years, typically in the late 50s and 60s when earned income may have stopped while Social Security and pension distributions have not yet started, are your tax planning opportunity window.  Depending on your earnings, interim distributions from tax deferred accounts may be taxed at lower income tax rates and are the perfect funding source for a Roth IRA. Once you reach age 70 ½ and have to begin your RMD distributions, you may be pushed into higher tax brackets and your tax planning opportunities may be severely limited.

In 2015, the IRS provision that allows IRA owners, who are age 70 ½ and older, to donate up to $100,000 directly from their IRAs was made permanent. This is a wonderful way for those with charitable intent to support their favorite charities and save taxes at the same time. The RMD gifting rule allows donations, up to $100,000, to be distributed directly from an IRA to a qualified charity, by-passing the adjusted gross income line on your tax return. This reduction in your adjusted gross income (AGI) can help reduce taxes, as follows:

  • Distributions to charities are effectively 100% tax deductible, which avoids restrictions where charitable contributions may be limited to 50% of modified AGI
  • They offer the tax benefits of a charitable contribution without having to itemize deductions on your tax return
  • Reduced AGI may help avoid the 3.8% surtax on net investment income
  • Reducing AGI may help avoid an increase in Medicare Part B premiums
  • Reduced AGI will help or avoid the negative affect on the taxability of Social Security benefits

Please contact us if you want to arrange a charitable contribution directly from your IRA, or if you or your family members want to know more about planning around RMDs. Planning early for retirement account distributions may save considerable income taxes over a lifetime.