Understanding the Impact of Required Minimum Distributions

 

The required minimum distribution (RMD) applies to all employer-sponsored defined contribution retirement plans which includes profit sharing plans, 401(k) plans, 403(b) plans, 457(b) plans, and the Thrift Savings Plan (TSP) (both the traditional and the Roth TSP), and traditional IRAs. The RMD rules also apply to IRA-based retirement plans such as SEPs, SARSEPs, and SIMPLE IRAs. But the RMD rules do not apply to Roth IRAs.

This column discusses the RMD rules and why they must be a part of a federal employee’s retirement planning.

How Do the RMD Rules Work?

The purpose behind the RMD rules is to limit the time retirement plan assets can grow tax-deferred by forcing qualified plan participants and traditional IRA owners to begin taking annual distributions no later than their required beginning date (RBD). In general, the RMD rules for traditional IRAs and defined contribution plans – defined contribution plans include both the traditional and the Roth TSP – are almost identical with some differences, as summarized in the following chart:

Note that this chart highlights some differences between the RMD rules as applied to traditional IRAs (not Roth IRAs) and to defined contribution plans, such as the TSP, 401K) and profit-sharing plans.

RMD Rules for IRAs

The following are some other RMD rules that IRA and retirement plan owners should be aware of:

• Penalty for not taking the RMD. If the annual distribution for an IRA or a defined contribution plan is less than the RMD, the shortfall is subject to a 50 percent IRS excess accumulation tax penalty. The 50 percent penalty is called the “tax on excess accumulations” and equal to 50 percent of the difference between the RMD and was not withdrawn. Note that the penalty is imposed for every RMD that is not withdrawn.

• Multiple distributions allowed. The annual RMD can be taken in more than one payment as long as the total distributions for the year are at least as the required amount.

• Distributions exceed RMD. If in any year an individual IRA or defined contribution plan owner receives more than that year’s RMD, the owner cannot apply the excess against the RMD required for any future tax year. The exception to this is any amount distributed in which the owner becomes age 70.5 counts towards the amount that must be distributed by April 1st of the following year.

What is the Required Beginning Date (RBD)?

The RBD depends on: (1) The type of retirement plans – IRA or a qualified retirement plan; (2) for qualified retirement plans, including the TSP, whether the plan participant is retired at 70.5 or continues to work past 70.5; and (3) for a qualified plan sponsored by a private employer, whether the plan participant owns more than five percent of the plan.

Note that an individual reaches age 70.5 on the date that is six months after the date of his or her 70^th birthday. For example, if an individual’s 70^th birthday was on June 24, 2017, then the individual reached age 70.5 on Dec. 24, 2017.

The following chart summarizes the RBD for lifetime distributions:

Required Beginning Date (RBD) – Lifetime Distributions

The following three examples illustrate:

Example 1. Paul, age 70, is a Federal employee with a TSP account. Paul intends to remain in Federal service throughout 2018. Paul also has traditional IRAs and a 401(k) retirement plan that he contributed to when he worked for a private company. Paul is not required to make an RMD from his TSP during 2018 because he is continuing to work in Federal service. But Paul must make his first RMD from both his IRA and his 401(k) retirement plan no later than April 1, 2019, the April 1^st following the year Paul becomes age 70.5.

Example 2. Jean, age 69, retired from Federal service four years ago at age 65 and has a TSP account. Jean will become age 70 on May 11, 2018 and will become age 70.5 on Nov. 11, 2018. Jean has until April 1, 2019 to make her first TSP RMD.

Example 3. Harry, age 68, will become age 69 in February 2018. Harry intends to remain in Federal service until he is age 75 in order to continue contributing to his traditional TSP account. Harry also has multiple traditional IRAs, a SEP IRA and a 401(k) retirement plan that he previously contributed to while working for a private company. Harry knows that as long as he remains in Federal service past age 70, he does not have to take RMD from his TSP. But he knows that he must take his first RMD from both his IRAs and his 401(k) no later than April 1^st following the year he becomes age 70.5 (April 1, 2020). Harry directly transfers his 401(k) and all of his IRAs to his traditional TSP (using Form TSP-60) before Dec. 31, 2018. He does these direct transfers in order that his 401(k) plan and IRAs all have a zero balance as of Dec. 31, 2018. His first RMD on these accounts, based on his account balance as of Dec. 31, 2018, due no later than April 1, 2020, will therefore be zero.

How Are the RMDs Calculated During an IRA or a Retirement Plan Owner’s Life?

The RMD for each distribution calendar year is the account balance divided by the distribution period listed in the Uniform Lifetime Table as shown here  (PDF, page 62) for the participant’s age at the end of the distribution calendar year. The exception is if the owner’s sole beneficiary at all times during the year is a spouse more than 10 years younger than the IRA or defined contributing plan owner. In that case, the Joint Life and Last Survivor Expectancy Table as listed here  (PDF, pages 47- 58) is used.

Determining the account balance – IRAs. The account balance used in computing the RMD for any distribution calendar year is normally the traditional IRA value as of December 31^st of the preceding calendar year. But if a rollover from a retirement plan or another traditional IRA is pending on December 31^st, meaning that the distribution was made but the funds did not reach the receiving IRA, then the account balance of the receiving IRA should be increased by the rollover amount.

The following two examples illustrate:

Example 1. Carl has a traditional IRA valued at $90,000 on Dec. 31, 2017. Carl was born on Sept. 13, 1947 and will become age 70.5 on March 13, 2018, and will be age 71 by the end of 2018. Carl’s IRA RMD for 2018, which can be taken as late as April 1, 2019, is:

$90,000 (IRA value as of Dec. 31, 2017)/26.5 (life expectancy factor for age 71) = $3,396

Example 2.  Mildred has a traditional IRA valued at $90,000 on Dec. 31, 2017. Mildred was born March 20, 1948 and will become age 70.5 on Sept. 20, 2018 and will not be 71 at the end of 2018. Mildred’s IRA RMD for 2018, which can be taken as late as April 1, 2019, is:

$90,000 (IRA value as of Dec. 31, 2017)/27.4 (life expectancy factor for age 70) = $3,285

Determining the account balance – defined contribution plans (including the TSP). The RMD for a distribution calendar year is based on the account balance as of the last valuation date in the valuation year. This is normally the calendar year immediately preceding a distribution calendar year, which in this case is Dec. 31. The following example illustrates:

William, age 71 years old during 2018, is married and a retired Federal employee with a TSP account. William’s wife is three years younger than him. William’s TSP account balance as of Dec. 31, 2017 was $530,000. William’s TSP RMD for 2018, which must be made no later than Dec. 31, 2018, is calculated as follows.

$530,000 (TSP account balance as of Dec. 31, 2017)/26.5 (life expectancy for married TSP owner with spouse within 10 years of the TSP owner) = $20,000

Suggestions for Minimizing the Tax Consequences of the RMDs

Two suggestions for minimizing or avoiding the tax liabilities associated with taking RMDs are:

1. Not delaying the first RMD until April 1 of the year after the individual turns age 70.5, or in some cases, retires). If an individual becomes age  70.5 in a particular year but waits to take his or her first RMD until sometime between Jan. 1 and March 31 of the following year, then the individual will have to take another RMD for the following year, the year after he or she becomes age 70.5. This second RMD would have to be taken by Dec. 31 of the following year. Taking two RMDs in one year may have adverse tax consequences such as (a) increasing the taxable income possibly pushing the individual into a higher tax bracket; (b) subject the IRA owner or the retirement plan participant to the 3.8 percent net investment income (NII) tax; or (c) cause additional Social Security benefits to become taxable.
2. The use of Qualified Charitable Distributions (QCDs), as discussed in another column. QCDs allow IRA owners to meet all of their RMD obligations. Available only to IRA owners age 70.5 or older, the maximum annual exclusion for QCDs is $100,000.

Federal employees and retirees becoming age 70.5 during 2018 – those individuals born between July 1, 1947 and June 30, 1948 – are encouraged to begin planning now for any distributions required during 2018. Note that an IRA trustee must either report the amount of the RMD to the IRA owner or offer to calculate it for the owner. Often the trustee shows the RMD amount in Box 12b of IRS Form 5498. For a 2018 RMD, this amount would be shown on the 2017 Form 5498 that is normally issued in January 2018. It is important to note that although the IRA trustee may calculate the RMD, the IRA owner is ultimately responsible for determining the amount of the RMD and withdrawing it.

The TSP does in fact provide all retired TSP participant owners age 70 and older of what their RMD is each year. Once informed of their TSP RMD, a TSP account owner can request monthly payments in order to achieve the RMD for that year. If, for some reason, a TSP owner’s RMD is not achieved by mid-December of a particular year, the TSP will send a check to the account owner from the owner’s TSP account for an amount that will achieve that year’s RMD, thus avoiding any IRS excess accumulation penalty.