Retirement savers who turned 70 in the first six months of 2014 have an important deadline coming up. April 1 is your last chance to take your first required minimum distribution (RMD) from your IRA, 401(k), and most other retirement accounts. That’s not a deadline you want to miss. If you neglect to take your RMD, the IRS will hit you with a hefty 50% excise tax on whatever amount you should have withdrawn from your retirement account but didn’t.
Yet people are dropping the ball on their RMDs and losing money in the process. Many retirees “continue to leave themselves vulnerable to significant tax penalties when their withdrawals are not made in a timely fashion,” noted Kim Reingold of Fidelity Investments, as reported in the Wall Street Journal. Fortunately, it’s easy to avoid the RMD penalty, provided you understand when and how the IRS expects you to withdraw money from your retirement accounts.
Why the IRS wants you to tap your 401(k)
RMDs exist because the IRS wants you to eventually pay tax on the money you saved for retirement. When money goes into your traditional IRA, 401(k), 401(b), or similar account, you don’t have to pay taxes on it. But the government hasn’t forgotten about this money — it’s simply waiting to get its hands on its share of your savings.
To prevent money from sitting in retirement accounts indefinitely without being taxed, the IRS requires you to withdraw a certain percentage of your savings every year after you reach age 70½. You also have to take RMDs on Roth 401(k)s, even though you’ve already paid tax on that money.
Roth IRAs are the lone exception to the RMD rule. You can leave money in your Roth IRA untouched for as long as you like, perhaps with the goal of passing the money to your heirs, who will continue to benefit from the account’s tax-free status (people who inherit a Roth IRA do have to take RMDs, however).
Is it time to take an RMD?
For most people, RMDs from IRAs, 401(k)s, and similar accounts must start by April 1 of the year after they turn 70½. One exception is if you are still working, in which case the IRS lets you delay your RMD from your 401(k) — but not your IRA — until you officially retire.
Let’s say your last birthday was on May 18, 2014. You turned 70½ on November 18, 2014. That means you have until April 1, 2015, to take your first RMD from your IRA. If your last birthday was July 18, 2014, and you turned 70½ on January 18, 2015, you have until April 1, 2016, to take your first RMD.
While the IRS gives you some extra time to make your first mandatory IRA withdrawal, it’s less generous when it comes to future withdrawals. All subsequent RMDs must happen by December 31. That means that if you take your first RMD on April 1, 2015, you’ll have to take a second withdrawal by December 31 of this year. Miss the second withdrawal and you’ll get hit with that 50% penalty. Not fun.
If your first RMD deadline is coming up, you should have received a notice from your account custodian. But these notices are easy to miss, especially if you have multiple accounts with different providers. Your custodian may calculate how much you need to withdraw from your account, or you may have to do it yourself. In either case, the withdrawal amount is determined by dividing the account’s value on December 31 of the previous year by your life expectancy (based on the IRS’s life expectancy tables).
If you have multiple IRAs, you can take the RMD in whatever way you choose — either from one account or spread among all or several accounts. But if you have multiple 401(k)s, you must take a separate RMD from each one.
The IRS is watching
Don’t make the mistake of thinking that the IRS won’t know if you skipped your RMD. Account custodians are required to share information about which accounts have reached RMD status with the IRS, and the tax man will eventually track you down. Still, there are a lot of people who miss the deadline. More than 255,000 people failed to take RMDs in excess of $348 million in 2006 and 2007 alone, according to a report from the Treasury Inspector General.
If you do miss your RMD deadline, don’t panic, but take steps to correct the situation. Elder-law attorney Ronald Fatoullah suggests that you take the missing RMD immediately and then let the IRS know about the mistake by filing Form 5329 and including an explanation for why you missed the deadline. If you have a good excuse, like you were suffering from a serious illness or received bad guidance from a financial adviser, the IRS may cut you some slack. “The IRS can waive part or all of the 50% penalty if you can show that any shortfall in distributions was due to reasonable error and that you’re taking steps to remedy the situation,” Fatoullah explained in an interview with Kiplinger magazine.
Like them or not, RMDs are a retirement reality for many people. In order to make the most of the money you’ve saved for retirement and avoid steep tax penalties, it’s best to start thinking about your RMD strategy well before the deadline for your first withdrawal approaches.