Required Minimum Distributions (RMDs) have been in the financial news a lot lately. There is much confusion about RMDs and hopefully, we can clear some of that up.
For many years, the way to save for retirement was in pretax accounts. The money went into the investment account before taxes were paid on the contributions. While the funds are in the accounts, they are growing tax-deferred. You are not required to pay taxes on the earnings or the growth until distributions are taken from the account.
When you were putting money into your 401(k), 403(b), or 457, you were putting it in pretax. To clarify – these names come from the IRS code sections that describe the rules for that particular type of account. A 401(k) is a retirement plan for those in a for-profit business. Some employees know them as TDSPs (tax-deferred savings plans). IRS code section 403(b) describes the retirement plans used by non-profit and educational institutions. Teachers most often contribute to these types of plans. 457 plans, also known as deferred compensation plans, are the voluntary plans that government employees can choose to contribute to.
There are some lesser-known retirement plans. Keoghs, SEPs, and Simple IRAs are employer plans often used by small businesses since the administrative costs for setting up these plans tend to be less. Profit-sharing, defined benefit, and pension plans are also used by employers that want to contribute to an employee’s retirement. These plans do not allow for employee contributions and are often used in addition to another type of retirement plan that allows employees to contribute to. A sole proprietor can use a solo 401(k) with no employees.
While these plans have many similarities, they also have many differences. Each has different maximum contribution levels. The portability is different in each account type. There are some common exceptions to avoid an early withdrawal penalty if you are under the age of 59 ½, but some are unique to particular plan types. Some of the plans have loan provisions and others do not. Employers can elect to make matching contributions into some of the plans and do not have that option in other plans. Some of the plans have mandatory employer contributions, while for other plans, employer contributions are voluntary. 403(b) plans allow for catch-up contributions while the other plans do not.
In addition to all these work-based plans are individual retirement accounts (IRAs). IRAs are an investment account that you chose to do outside of work. Traditional IRAs allow for tax-deductible contributions if you do not exceed the income limits. If you exceed the income limits, you cannot take a deduction for the amounts you put into the IRA. In both the deductible and non-deductible Traditional IRAs, the earnings grow tax-deferred. Like with the employer plans, you will not pay taxes on the earnings until distributions are taken. In a deductible IRA, the full amount of the distribution will be taxable. If contributions were non-deductible, each distribution would be partially taxable and partially tax-free. The return of the non-deductible contributions makes each distribution partially tax-free.
With The Tax Act of 1997 came Roth IRAs. Roth IRA contributions are not tax-deductible. There is a critical difference between a non-deductible Traditional IRA account and a Roth IRA account. For a Roth IRA, the earnings grow tax-free and no taxes will be paid as long as you make qualifying distributions – no taxes due on the contributed amounts and no taxes due on the earnings as the account grows. In the non-deductible Traditional IRA, you will pay taxes on the earnings, but not on the contributed amounts as distributions occur.
Companies were able to add Roth 401(k)s to their existing 401(k) plan starting in 2006. In the last few years, individuals also can make Roth 403(b) contributions and Roth 457 contributions. The sticking point to these contributions – the plan documents must first be amended by the plan administrators before employees are eligible to make these contributions.
Many companies, school districts, and governmental agencies have made those amendments and now allow Roth contributions to be made. Some employers have not yet done this and may need some coaxing by employees before they add the option to make Roth contributions.
There are changes to the rules and regulations being made by Congress and the IRS regarding all the various employer plans. The intent is to move towards all plans having the same rules – same contribution limits, same exceptions, same loan provisions, and the same options under all employer plans. This would be true for both the pretax and Roth contributions.
Individuals have access to funds in these retirement accounts any time after age 59½ without penalties. In the case of the employer plans, most employers also require you to retire and no longer work for the company. There are some exceptions to avoid penalties like the age 55 and separation of service rule or using the IRS 72(t) rules. Until age 70½ or age 72, depending on your date of birth, any distributions out of these accounts are voluntary. You can take as little or as much as you want in distributions.
Required minimum distributions exist to have individuals take money out of these pretax or tax-deferred accounts. Until the start of 2020, RMDs were required to start at age 70½. Under the SECURE Act that passed in late 2019, the new age is 72 for anyone who had not attained the age of 70½ by the end of 2019. The age 70 ½ or age 72 RMD is when the federal laws requires you to start taking distributions. Your employer’s plan may have requirements for you to start distributions at an earlier age.
RMDs are the minimum that someone has to take. There is always the option of taking more than that. If you fail to take your RMD, you will be subject to a 50% excess penalty. RMDs are calculated so that the amount in the accounts should last until age 100 if only the minimum amounts are taken. The RMD amount is determined by the prior year ending balance, by your age, and your beneficiary’s age.
The intent of RMDs is for individuals to start paying the taxes on these tax-deferred amounts. For that reason, there are no RMD requirements on Roth IRAs. Requiring distributions from Roth accounts would not create any tax liability.
Employer retirement plans do have distribution requirements for both pretax and Roth accounts. Leaving Roth contributions and earnings in a 401(k), 403(b), or 457 would not be a good idea if you do not need the income after reaching the RMD age. Transferring these funds to a Roth IRA would allow you to continue the IRA’s tax-free growth instead of being required to take the funds out of your employer’s plan.
We often hear – I do not need the income; can I just leave the funds in the IRA or the employer’s plan? Failure to take that distribution results in that 50% penalty being charged, making this not a good idea.
Our suggestion – take the dollars from the RMD and use them to pay taxes on doing a Roth conversion for other tax-deferred dollars. Consider if your RMD amount is $12,700. Take the $12,700 and have 80% in federal taxes withheld. 80% in federal taxes withheld would be $10,160. If you are in the 22% federal tax bracket, you would have paid in enough in taxes to cover $46,180 of income. The $46,180 less the RMD of $12,700 means you could do a Roth conversion of $33,480 and not make an out-of-pocket tax payment. Use the other 20% to pay in any state taxes you owe or receive a small cash payment. Potentially you could do 90% or 95% in federal withholding to allow for a larger conversion.
Doing this transaction means you have taken your RMD and avoided penalties. By converting the $33,480, you now have that amount growing tax-free for the future. And – because you have taken that amount out of your Traditional IRA, your RMD in the next year would be smaller since the 12/31 balance in the account will be less.
This conversion technique does not work in employer retirement plans. At this time, Roth conversions are not allowed inside a 401(k), 403(b), 457, or any employer retirement plan. To take advantage of this Roth conversion technique, you would have to roll over your funds from the employer plan into a Traditional IRA. You could then do your RMD from the Traditional IRA and convert what you want into the Roth IRA.
A final note about RMDs: inherited retired accounts have mandatory RMDs regardless of the beneficiary’s age and regardless of the type of account. Most employers will not allow you to leave inherited funds within the plan. These investments would need to be rolled into a beneficiary Traditional IRA or a beneficiary Roth IRA. The exception being that spouses can elect to roll them into their own IRA accounts.
All beneficiary IRAs have RMDs regardless of the IRA type. The SECURE Act changed the distribution rules and that is a post in itself for a later time.
Be sure to read the next post about the taxability of RMDs and more specifics about distribution requirements.