The Right Way to Tap Your IRA in Retirement

Finally, you have reached retirement age and all of your financial planning should have paid off.  It’s time to kick back and enjoy your decades of hard work. But once you retire and start taking money out of your IRA, penalties and taxes can take a big chunk out of your nest egg. Be prepared not to drop the ball at this important phase of retirement.

Required minimum distributions from your IRA can be tricky.  Deb Repya, senior director of Advanced Markets for Allianz Life Insurance Company of North America offered the following tips every boomer needs to know about tapping into an IRA.

Boomer: What is a Required Minimum Distribution (RMD)?

Repya: A required minimum distribution or RMD applies to certain older individuals who own a traditional IRA, but not to owners of a Roth IRA. RMD's may also apply to participants of certain qualified retirement plans such as 401(k) plans, and to certain individuals who are beneficiaries of any IRA after the owner dies, whether traditional or Roth IRA,  and to beneficiaries of qualified plans like 401(k) plans.

For purposes of these questions, let's focus on the RMD rules for certain older individuals who own a traditional IRA.

Traditional IRA owners must start to take distributions from their IRA by April 1 of the year following the year that the IRA owner turns age 70 1/2.  The distribution for that first year must be taken by that date.  In the subsequent years, the distribution must be taken by December 31. Thus, if someone delays the first distribution until April 1 of the year after age 70 1/2, they will have to take two distributions in that year. While this is a minimum distribution, there is no maximum. In any year, the individual IRA owner could always take more than the RMD amount. However, the tax deferral that the IRA provides may be important to the IRA owner and should be considered before taking additional IRA distributions.

Boomer: How are RMDs calculated?

Repya: To calculate the RMD for any given year, determine the value of the IRA on December 31 of the prior year and divide that by the life expectancy of the IRA owner using IRS tables. The life expectancy factor is found in the IRS' Uniform Lifetime Table which is published in IRS Publication 590. However, if the sole beneficiary of the IRA is a spouse who is more than 10 years younger than the IRA owner, then the life expectancy factor in the IRS' Joint Life Table may be used instead. If the IRA owner has a spouse as the sole beneficiary and that spouse is more than 10 years younger, it may be beneficial to use the Joint Life Table since it allows for a smaller distribution for the RMD due to a larger life expectancy factor.

Assume we have someone who has $1 million in a traditional IRA (valued at year end), who turned age 70 1/2 this year, and whose spouse is not more than 10 years younger. The RMD for that individual for this first RMD year is $1 million divided by 27.4 (the IRS factor from the Uniform Lifetime Table) or $36,496.

The amount of each RMD is calculated separately for each IRA. However, the RMD amounts for the separate IRAs may be totaled and the aggregated RMD amount may be paid out from any one or more of the IRA accounts.

Most IRA providers, whether an insurance company or broker/dealer, will calculate the RMD for those traditional IRAs held by that provider.

Boomer: When must I receive my required minimum distribution and what penalties would apply if I don’t take an RMD by the required deadline?  Can this type of penalty be waived.

Repya:  There is a possible waiver of the 50% additional tax if the RMD was not taken by the deadline. The IRA owner should take the RMD as soon as possible after the IRA owner realizes the RMD deadline was missed. Then the IRA owner should notify the IRS of the mistake by completing IRS Form 5329 and the relevant sections on Required Distributions and Waiver of Tax. The reason for missing the deadline should be included with the information filed. The IRS may waive the 50% additional tax for reasons such as hospitalization, a natural disaster, etc. The IRS has flexibility to potentially waive the penalty depending on the circumstances.

Boomer: Are RMD’s taxed and if so how?

Repya: Yes, all distributions from a traditional IRA are taxed as ordinary income, except to the extent that they represent funds that were not deducted from income tax when they were contributed to the IRA. In general, if all or part of any of your IRA contributions were not deducted from income taxes, then a portion of each RMD will be taxed, and a portion will be tax-free. Failure to withdraw the annual RMD will trigger a penalty tax equal to 50% of the excess of the amount that should have been withdrawn over the amount that actually was withdrawn.

Boomer: Can a distribution in excess of the RMD for one year be applied to the RMD for a future year?

Repya: There is no dollar-for-dollar reduction in your RMD for future years if you take more than your RMD in one year. However, if you take more than your RMD in one year, it could potentially mean that the balance in your IRA account is smaller when you do the RMD calculation for the following year, thereby resulting in a smaller RMD potentially for that following year.

Boomer: Are there any other special IRA rules that could be considered for someone who is subject to RMDs after age 70 1/2?

Repya: Yes.  Tax law did allow for 2013 and some prior years a special provision for qualified charitable contributions.  As of the date of this writing, Congress has not extended that for 2014, but it is possible Congress could extend it for 2014.  That special provision would allow an IRA owner age 70 1/2 or older to exclude from taxable income any transfer of up to $100,000 from a traditional  IRA to a qualified charity and use it to satisfy their required minimum distribution or RMD for that year. The transfer must be made directly from the IRA account to the charity.  Check with a tax professional before year end 2014 to determine whether Congress has extended this provision.