The Five Steps of IRA Distributions
Evan P. Kaplan, CFP®
Where will your income come from in retirement? For many, individual retirement account (IRA) distributions comprise an important part of their retirement income and are often the result of decades of hard-earned savings. Understanding the ins and outs of IRA distributions will enable you to make the best decisions when it comes time for you to kick back and relax. So follow these five steps and remember to consult a financial professional if you need more guidance.
Step 1: Understand the type of IRA accounts you own.
- Tax-deferred IRAs
These include traditional, SIMPLE, and Simplified Employee Pension (SEP) IRAs and provide investors with a tax-deductible contribution and tax-deferred growth; however, distributions are taxed as ordinary income and are required to start at age 70½. Note that it’s possible to make non-deductible contributions to a traditional IRA, but that’s an article for another day!
- Tax-exempt IRAs
Tax-exempt IRAs, known as Roth IRAs, offer a different advantage: contributions are made with after-tax dollars, but owners benefit from tax-free growth and distributions. Since distributions are not required until after the death of the owner, in this article we’ll focus in on tax-deferred IRAs.
Step 2: Learn the different distribution types and the rules associated with them.
The three types of distributions for tax-deferred IRAs are:
- Early Distributions – occur prior to the IRA owner turning 59½
Early distributions may be subject to a 10% penalty (in addition to ordinary income tax) unless an exemption applies (e.g., health insurance premiums that are paid while a person is unemployed, certain distributions that are made to qualified military reservists called to active duty, and certain other hardship situations).
- Normal Distributions – occur between ages 59½ and 70½
Normal distributions may be made without penalty, but are not yet required.
- Required Minimum Distributions (RMDs) – occur upon turning 70½
- Beginning the calendar year you turn 70½, the IRS requires you to start taking your annual RMD by December 31st of that year.
- The one exception is an option to delay your first RMD payment until April 1st of the following year. However, if you choose this option, you’ll have to take two years’ worth of RMDs that following year, which could push you into a higher income tax bracket.
- If you fail to take your RMD, the IRS will impose a 50% penalty for the amount not taken.
- As implied by the name, the RMD is the minimum amount you must take; you can always distribute more from your IRA than the RMD but this may have negative tax consequences.
Step 3: Calculate your RMD.
While the IRS requires the institution that holds your tax-deferred IRA to calculate the amount of your annual RMD and provide it to you and the IRS, you are ultimately responsible for taking the correct amount so it’s important to understand how this works:
- First, determine the prior December 31st value of your tax-deferred IRA.
- Next, divide that number by your current life expectancy factor published by the IRS here (unless your spouse is the sole beneficiary of your IRA and he or she is more than 10 years younger than you).
- Repeat for each of your tax-deferred IRA accounts. You may take the aggregated total RMD for all of your traditional, SIMPLE, and SEP IRAs from any one of those IRA accounts as long as it has a sufficient balance to cover the aggregated RMD.
Step 4: Know what to expect in taxes.
Distributions are taxed as ordinary income based on your federal income tax rate (plus state and local taxes if applicable) which in total can exceed 40% of your overall RMD! This income could set you into a higher tax bracket and increase the taxes you pay on your Social Security benefits or cause your Medicare premiums to increase. This could also trigger the 3.8% net investment income tax on the interest, dividends, and capital gains earned in your investment portfolio. If you are charitably inclined, one solution to this problem is to reduce your taxable income via a qualified charitable distribution.
Step 5: Decide if qualified charitable distributions (QCDs) are a good option for you.
For traditional IRA owners, once you turn age 70½ you can make contributions of up to $100,000 per year in QCDs to one or more qualifying charities (QCDs may only be made from SIMPLE or SEP IRAs if they’re no longer receiving ongoing employer contributions). Since IRA distributions are taxed as ordinary income, this is a tax-efficient strategy to fulfill charitable giving goals while reducing your taxes.
For example, suppose your annual RMD is $130,000. You give $75,000 to Charity A, $25,000 to Charity B, and transfer the remaining $30,000 to your bank account. Since $100,000 was distributed directly to charity, it’s not reported as taxable income. You only pay taxes on the $30,000 distributed to yourself (note you can’t receive a charitable deduction on your tax return for charitable gifts made using a QCD).
And here’s a bonus tip: if you are making contributions into a SIMPLE or SEP IRA and you have turned age 70½, you may take that account’s RMD in the form of a QCD from another IRA account which qualifies for QCDs.
Receiving or gifting your distributions is not the hard part, it’s saving for retirement that takes a lifetime! So don’t drop the ball when it comes time to enjoy those hard-earned savings, make sure you optimize your retirement funds by knowing exactly how distributions work.