Helping Soon-to-be Retirees Understand RMD Rules

Are your employees reaching retirement age in the near future?  If you answered yes, are they cognizant of the required minimum distribution (“RMD”) obligations which begin when they turn 70 ½ years old for both their individual IRAs and 401(k) plans?  It’s crucial they are aware of what to expect when they attain 70 ½ for both financial and tax-planning reasons.

IRAs and 401(k)s

To avoid substantial penalties, existing employees must distribute RMDs from their IRAs when they reach age 70 ½.  Although, their first payment can be delayed until April 1st of the subsequent year after turning 70 ½.  However, if they’re still employed, they do not have to begin taking distributions from their 401(k)s.

Even though the regulations do not explicitly disclose how many hours employees must work to delay the 401(k) RMDs, they do state that the employee must be performing legitimate work which is reported as W-2 wages.  Note that there is a key exception though:  those employees who own at least 5% of the company must start distributing RMDs from the 401(k) as age 70 ½ is attained, regardless of their work status.

In the case that an employee has more than one IRA account, it does not matter which account he or she takes the RMD from, as long as the total amount reflects their combined IRA assets.  On the other hand, RMDs related to 401(k) plan assets are required to be taken specifically from the 401(k) plan account.

Sooner Rather Than Later

The IRS would rather tax income at an earlier rather than later date.  (The funds in a Roth IRA have already been taxed by the IRS, therefore, they are not subject to RMD requirements.)  A life expectancy table formulates how the IRS determines the RMD.  These amounts change on an annual basis as the retiree ages.

For instance, at age 72, the IRS “distribution period” is 26.5, which means that the IRS presumes that the participant will live another 26 ½ years.  Therefore, the participant will be required to withdraw 3.77 percent of the IRA or 401(k) account, which is calculated as 1 divided by 26.5.

Another example would be if a participant lived to age 90.  The distribution period would be 11.4, which would result in an 8.77% RMD.  While the percentage amount increases over time, the IRS regulations do not suggest the retirees empty out their accounts.  Nevertheless, based on the formula used by the IRS, it may discourage excess assets in retiree accounts when they become deceased.

Other Pertinent Facts

Other RMD particulars that could prepare your employees reaching retirement age:

Beneficiary spouses. There is a separate RMD formula for those account holders who have a beneficiary spouse at least 10 years younger than them.  This allows the participant to distribute smaller amounts to conserve their retirement assets for the younger beneficiary spouse.

Tax penalty. The tax penalty for taking out less than the required RMD amount is 50% of the portion that should have been distributed. Participants are required to pay the penalty first and then initiate a refund claim for the penalty.

Form of distribution. RMDs can be in cash or be distributed in the form of stock shares, whose value equals the RMD amount. Although this can be administratively troublesome, participants can avoid brokerage commissions on securities they do not wish to sell. Also, their tax basis in the stock (for future capital gains liability calculation purposes) resets to the value of the securities when they’re distributed.

Informed Participants

Keep in mind that well educated participants are happy participants.  It’s never too early to inform and prepare your employees approaching that retirement age about their RMD obligations. We recommend getting your benefits advisor involved to guarantee you’re providing the most current information.

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