Required minimum distribution rules are complex. Advisors deal with retirement accounts every day, but may be surprised by what they don’t know about RMDs. For many affluent clients, RMDs are a headache and a big piece of their tax bill at the end of the year. We will go over the RMD rules and exceptions, as well as look at ways for advisors to add value in reducing RMDs.
The SECURE Act increased the age for RMDs from 70½ to 72, for those whose 70th birthday was after July 1, 2019. In other words, if you were born after July 1, 1949, your RMD age is now 72. The deadline for taking your first RMD is called the required beginning date or RBD. Going forward, the RBD is going to be April 1 of the year after taxpayers turn 72. In all subsequent years, RMDs must be withdrawn by December 31 of each year.
RMDs were waived in 2020, as part of the CARES Act response to the COVID pandemic. However, RMDs are back for 2021. If this year is the first year a client is taking RMDs, please note that if they turned 72 by June 30, 2021, they must take their 2021 distribution by December 31. That’s because this should actually be their second year of RMDs. The CARES Act did not change the RBD. However, if clients turn 72 after July 1, 2021, they will have until April 1, 2022 to take their first RMD.
A client’s RMD is calculated on the value of all their “traditional” retirement accounts, from December 31 of the previous year. The 2021 RMD is based on the December 31, 2020 total value. Accounts include traditional IRAs, 401(k), 403(b), SEP IRAs, and SIMPLE IRAs. Additionally, qualified annuities, profit sharing plans, cash balance plans, and defined benefit pension plans are included in the RMD calculation.
What doesn’t count towards RMDs? Roth IRAs and non-qualified annuities. Strangely, there are RMDs for Roth 401(k) accounts, although a qualified distribution will be non-taxable to the client. Clients can and should rollover their Roth 401(k) to a Roth IRA to avoid the RMD and keep their Roth assets growing tax-free for longer.
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Once we reach January 1, we can calculate a client’s RMD for the year ahead. The calculation is simply the December 31 total value of qualified accounts divided by the IRS life expectancy table. This is found in IRS Publication 590-B, Distributions from Individual Retirement Arrangements.
For 2021 and previous years, the IRS Uniform Table produces a divisor of 25.6 for someone who is age 72 by December 31. If your client has $500,000 in qualified accounts, we divide that by 25.6 and their RMD is $19,531.25. Most clients (and advisors) think in percentages better than divisors. Describing the RMD for age 72 as 3.90625%, or about 3.9%, is easier to understand than a divisor of 25.6. Know the divisors, but you may want to use percentages when talking to clients.
Each year, the life expectancy is shorter, so at age 73 the divisor decreases to 24.7 (or approximately 4.05%). By age 80, the divisor is 18.7 (5.35%) and at 90, it is 11.4 (8.77%). RMDs go up each year!
Starting in 2022, the IRS is adopting a new life expectancy table and that means lower RMDs. For example, for age 72, the divisor will increase from 25.6 to 27.4, or 3.91% to 3.65%. This will reduce RMDs across the board for your clients. Please note that first-year RMDs (i.e. a client turning 72 in 2021), will use the 2021 table even if they wait until April 1, 2022 to take the RMD.
“If a client fails to take an RMD or takes less than their RMD, the penalty is 50%. And the missed RMD will be added to the next year and will still be taxable!”
If a client fails to take an RMD or takes less than their RMD, the penalty is 50%. And the missed RMD will be added to the next year and will still be taxable! It is important to get RMDs correct. If your client is in hot water for an RMD error, there is a process to request leniency on the 50% penalty.
RMDs and Spouses
Most people will use the standard uniform table to calculate their RMD, with one important exception. If a spouse is the sole primary beneficiary of an IRA, and is more than 10 years younger, you will use the joint life expectancy table to find the divisor and calculate the RMD. For example, my wife is 15 years younger than I am. At 72, my RMD would be approximately 3.425% instead of the usual 3.9%. The thought here is that if one’s spouse is younger, they will need the money to last longer, and so the IRS offers a small reduction in the RMD calculation.
Please note three things. First, your client’s marital status for RMDs is as of January 1 for that year. If your client becomes divorced or widowed during the year, they do not have to change their RMD calculation. The next year, however, your client would revert to using the uniform table. Second, ages are based on one’s attained age at the end of the year, as of December 31. Months don’t count, only whole years. To get this discount, the spouse must be the sole primary beneficiary. If there are two primary beneficiaries, the client must use the standard uniform table. They can however, have contingent beneficiaries and still take the reduced joint RMD.
“Still Working” Exception to RMDs
If a client is still working past their required beginning date, they may be able to avoid an RMD from their employer retirement plan. They must work through the full year (December 31) to avoid an RMD. This waiver only applies to the client’s current 401(k), 403(b), or other employer defined contribution retirement plan. It does not apply to 401(k) plans held with previous employers.
If your client’s last day of employment is December 31, they are considered retired at the end of the year. They will owe an RMD for that year. To avoid an RMD, they should make their last day January 1 or later.
The “still working” exception does not apply to any type of IRA, including SEP or SIMPLE Plans. If your client wants to work past 72 and avoid RMDs, they might want to consolidate their old 401(k)s or IRAs into their current plan. If they leave the assets in the old 401(k)s or rollover to an IRA, they will have to take an RMD on those accounts. Confirm if their plan allows current employees to roll-in assets and complete any transfers before December 31 of the year before they turn 72.
The “still working” exception is not available to a business owner who owns more than 5% of the company. For RMD planning for business owners, please see this article from Jeffrey Levine.
The IRS does not require that an employee must work full-time to qualify for the exception. There is no test for the minimum number of hours worked or salary earned. So, it’s possible that working even a few hours a month could save your clients from RMDs.
Although the IRS might waive RMDs, a company plan could still require RMDs at age 72 and not make an exception for current employees. If that is the case, the plan rules override the IRS exception. Check the summary plan description before assuming there will be no RMD after 72.
If an employee is on short-term disability, they may be able to defer RMDs, as long as their employer deems them still employed. If they are on permanent disability, they are probably no longer considered an active employee and will have to resume RMDs.
Most of the RMD rules are the same for IRAs and for employer sponsored plans. Each account should calculate the RMD for that account. In the case of IRAs, however, it does not matter which account is used for the withdrawals. As long as the total amount of RMD is fulfilled for the year, the amount per account is irrelevant. A client could have four IRAs and take withdrawals from just one, if they wanted.
That’s not the case for employer plans (401(k), 403(b), etc.) —participants must fulfill the actual RMD for each account. They cannot take a 401(k) RMD from a different 401(k) or from an IRA. (See IRS comparison chart of RMDs from IRAs and Defined Contribution Plans).
The IRS considers any IRA distribution to be pro rata from all sources. If a client has one IRA with after-tax contributions, they may have thought that they could take distributions from that account and have lower taxes. Unfortunately, the pro-rata rule makes this irrelevant. It doesn’t matter how many accounts you have; for IRS purposes, it is treated as one IRA.
Generally, there is not a lot we can do about RMDs after January 1. After all, they are required! However, besides the “still working” exception there are a number of strategies advisors can use to reduce RMDs for clients who don’t need the cash and want to avoid the taxes.
- Consider Roth conversions. Those done prior to age 72 can reduce the size of their traditional IRAs.
- Think about qualified charitable distributions. QCDs count towards RMDs, but are non-taxable. When the age for RMDs was increased from 70½ to 72, Congress did not change QCDs, so clients can still make QCDs once they reach age 70½. QCDs do not require clients to itemize. They can take the standard deduction and still get a reduction in their taxable income. Clients can donate up to $100,000 a year through QCDs, even if this amount exceeds their RMD calculation.
- Look into qualified longevity annuity contracts. QLACs can allow investors to defer RMDs up to age 85. QLACs are limited to 25% of the investor’s retirement account or $135,000, whichever is less. A QLAC is appropriate for someone who is concerned about longevity risk, doesn’t need current income, and wants to establish a future income stream.
- Employ other accounts. Clients who are retiring may have an opportunity to reduce their future RMDs two ways. First, does your client have after-tax contributions to their 401(k)? Many plans will allow participants to split the after-tax amount into a separate check that can be rolled into a Roth IRA. Second, does your client have any company stock in their 401(k)? If so, they may be able to roll out those shares into a taxable brokerage account, under the Net Unrealized Appreciation (NUA) rules.
- Examine asset allocation. Since RMDs are taxable as ordinary income, it may be preferable to hold bonds and low-growth investments into traditional IRAs. This will result in lower account balances and lower RMDs over time. Higher growth investments could be placed into Roth IRAs for tax-free growth or into taxable accounts to receive preferable long-term capital gains treatment. This is not an investment recommendation for bonds, but simply how to locate assets into the most tax-efficient account long-term.
RMDs on Inherited IRAs
There are completely different calculations on RMDs for beneficiaries who inherit an IRA. For decedents prior to 2020, the Stretch IRA offered an ability to take annual distributions. For deaths after January 1, 2020, many non-spouse beneficiaries now must withdraw the entire inherited IRA within 10 years. There are several exceptions where Eligible Designated Beneficiaries can still use a Stretch IRA today. Spouses who inherit an IRA can roll the IRA into their own IRA or into a Beneficiary IRA. For details on distribution requirements for IRA beneficiaries, please see Stretch IRA Rules.
There is a proposal in Washington to increase the age of RMDs from 72 to 75. That would certainly help people who don’t need the income and who want to avoid the taxes. This might help people save for longer and reflects the longer life expectancy today. Advisors will also want to keep an eye on current legislation to limit or ban Roth conversions, which will hurt a very effective tool for reducing RMDs today.
The best time to discuss required minimum distributions with your clients is years in advance of age 72. That’s where advisors can add the most value and help clients reduce taxes. We can then plan for income when clients need it, not when the IRS forces them to take a distribution.
Scott Stratton, CFPⓇ, CFA, is the founder of Good Life Wealth Management, a Registered Investment Advisor in Little Rock, Arkansas. He can be reached at firstname.lastname@example.org.