If you own one or more traditional IRAs and you turned or will turn 72 this year, you are now exposed to the dreaded minimum distribution rules (RMD) required by federal income tax IRAs. These rules cause seasoned IRA owners like you to make annual taxable withdrawals from their traditional IRAs. The same RMD rules also apply to Simplified Employee Pension (SEP) and SIMPLE-IRA accounts. (In contrast, Roth IRAs set up in your name are exempt from RMD rules for as long as you live.)
As you may suspect, the rationale behind the RMD rules is to force people who would otherwise leave their traditional IRA balances intact to start making withdrawals and paying the resulting federal income tax. If you think the RMD rules are just a minor annoyance that you can safely ignore, think again. If you do not withdraw at least the RMD amount for the year, the IRS can impose a 50% penalty for the shortfall. That is one of the most punitive sanctions in our beloved Internal Revenue Code. Avoiding the penalty means complying with the RMD rules. So let’s do it. Here in the FAQ format is what you need to know to stay out of RMD trouble, considering the possibility that your marginal federal income tax rate could be higher next year if the tax proposals of President Biden are successful. You have two options on when to take your initial RMD, which is for the calendar year you reach the magical age of 72. Choosing Door No. 1 means taking it during the year you turn 72. Choosing Door No. 2 means taking your Initial RMD no later than April 1 of the year after your 72nd birthday. Regardless of which door you choose, the initial RMD is related to the calendar year in which you turn 72. Then, for each subsequent calendar year, you must take another RMD no later than December 31 of that year. Of course, you will also owe the federal impact related to income, and perhaps a state income tax as well, depending on where you live. Yuck! If you have turned or will be 72 this year, the important thing to understand so far is that you choose Door No. 2 means you must take two RMDs in 2022 to avoid the 50% penalty. The first RMD will be for calendar year 2021 (the year you reached magic age), and that must be taken by 4/1/22. The second RMD will be for calendar year 2022, and must be taken by 12/31/22. Confused? You gamble. Thank your beloved Congress (not the IRS) for all of this. Does choosing Gate 2 create a tax risk? Yes. If you turned or will be 72 this year, choosing Door No. 2 would create a double whammy of RMD in 2022, because you would have to make two mandatory withdrawals next year and pay the resulting double tax. That’s no big deal if you only have a modest amount in your IRA (s). So in that case, postponing the tax bill for your initial RMD until next year could make a lot of sense, especially if you expect to be in the same marginal tax bracket next year or a lower one. But if you have a lot of money in your account (s), taking two RMDs next year could push you into a higher tax bracket and also cause you to lose tax breaks that are phased out as income rises. That would be bad news in any year, but it could be especially bad news next year if Congress and President Biden work together to raise his tax rate by 2022. Biden wants to raise the top marginal federal tax rate from the current 37% to 39.6 %. It has stated that people with incomes less than $ 400,000 will not be affected by any tax increases. But it’s unclear what the $ 400,000 figure could mean. Does adjusted gross income mean (total income reduced by certain deductions such as contributions to the self-employed retirement plan and allowable cancellations for alimony payments)? Or does it mean taxable income (total income reduced by all allowed deductions, including itemized deductions or standard deduction, as applicable)? If the $ 400,000 figure is for married couples filing jointly, what about singles? Will they be affected by a higher tax rate if they have more than $ 200,000 of income (however defined)? As this was being written, we do not know the answers to any of these questions. Stay tuned, because we may have some details soon. What if I have multiple IRAs? If you have multiple traditional IRAs (including any SEP and SIMPLE-IRA accounts), your annual RMD amount is based on the combined balances of all those accounts. However, it is not necessary to withdraw the RMDs from each account separately. Instead, the required amount can be withdrawn from as few (or as many) IRA accounts as you like. For example, if you have three accounts, you can withdraw the full amount of RMD from a single account. How do I calculate the RMD? The one-year RMD depends on the combined amount of your traditional IRA balances as of December 31 of the previous year divided by a life expectancy figure provided by the IRS. The RMD amount must be recalculated annually, because the IRA balance is a moving target, and so is the life expectancy divisor. As you get older, the life expectancy dividers get smaller, meaning that annual RMDs become an increasing proportion of your combined IRA balances. Example: You are not married and turned 72 this year or will reach that age at the end of the year. To avoid a double tax hit by 2022, choose Gate No. 1 and take your initial RMD this year instead of next. It’s probably a good idea. Here is the exercise. Divide your combined IRA balances as of 12/31/20 by 25.6 (the life expectancy divisor for a 72-year-old from the IRS table. Suppose the combined balances were $ 500,000. RMD is $ 19,531 ($ 500,000 / 25.6). Make sure to withdraw at least that amount by 12/31/21 (you will get credit for any amount withdrawn at the beginning of the year). Next year, you should take your second RMD before 12/31/22. The amount required for next year will be the combined IRA balances of 12/31/21 divided by 26.5 (the life expectancy divisor for a 73-year-old person, which will be their age 12/13/22) And so on for each subsequent year point: In most cases, the custodian or trustee of your IRA will calculate the RMD amounts for you, but it doesn’t hurt to know the drill. We take nothing for granted! You are turning 72 this year. If you choose to take your initial RMD this year (Door No. 1), you will avoid the possible tax impact. nte damaging to have to take two RMD Ds next year. Again, this is only a major issue if you have a lot of money in your IRA (s). If you do, having to take two RMDs next year (because you chose Gate No. 2) could push you into a higher tax bracket. Perhaps higher than you think if tax rates go up next year. You could also lose some tax breaks next year due to the income-based elimination rules. Consider consulting your tax advisor if you find yourself in this situation, and take action before the end of the year if door number 1 appears to be the best option.