Revisiting RMDs and QCDs

04/10/21 | Birchbrook Team | Birchpapers

With the first quarter of 2021 in the books and tax season in full swing, many folks are wondering if Required Minimum Distributions (“RMDs”) from IRAs will be waived again this year as they were in 2020. As we have discussed in prior posts, the CARES Act of 2020 suspended RMDs from many retirement accounts, allowing account holders to opt out of these otherwise mandatory distributions. Since RMDs are generally included in taxable income, the 2020 waiver helped many taxpayers reduce the amount they will need to pay when they file their income taxes this year. It does not appear that IRA owners and retired qualified plan participants will receive an RMD waiver for 2021.

Let’s take a step back from taxes and revisit what the RMD is and who is required to take one. Your RMD is the minimum amount you must withdraw from your IRA, SEP IRA, SIMPLE IRA, or retirement plan account when you reach the age of 72 (or 70½ if your 70th birthday was before July 1, 2019.) You can take distributions from your IRA at any time. There is no need to show a hardship to take an IRA distribution. However, your distributions will be includible in your taxable income and may be subject to an additional 10% tax if you take a distribution prior to age 59½. If you take a distribution from your SIMPLE IRA in the first two years that you are a participant in the plan, the additional tax is 25% prior to age 59½. Roth IRAs have their own rules regarding how soon you may withdraw without penalty after opening the account (generally, five years after your first Roth contribution) and are subject to the 10% tax for distributions prior to age 59½ but a Roth owner is not required to take annual minimum withdrawals from their Roth IRA account at age 72, and Roth IRA withdrawals are generally not taxable.

Non-spouse beneficiaries of IRAs (including Roth IRAs) will be required to establish an Inherited IRA account and must begin withdrawals no later than December 31st of the year following the death of the original account owner. The entire inherited IRA must then be withdrawn within ten years. There is no annual minimum or maximum amount to withdraw from the Inherited IRA. But given that the whole account must be distributed within ten years, withdrawals can place a significant tax burden on the Inherited IRA owner, particularly if they are already generating substantial earned income. IRA distributions must be included in taxable income and are taxed as ordinary income. Inherited IRA owners are not subject to the additional 10% early withdrawal penalty for taking distributions prior to age 59½.

The rules for spousal beneficiaries and “eligible designated beneficiaries” are a bit different. Spousal beneficiaries are not required to take distribution of the entire account within ten years. Spousal beneficiaries can plan RMDs from an inherited IRA to take advantage of delaying the RMDs as long as possible. If the IRA owner dies before the year in which they reach age 72, then distributions to the spousal beneficiary are not required to begin until the year in which the original owner would have reached age 72. The spousal beneficiary may also choose to treat the inherited IRA as their own and use their own RMD required beginning date.

Now, back to the RMD. Your RMD for any year is calculated by dividing the IRA account balance as of December 31st of the immediately preceding calendar year by a distribution period from the IRS’ “Uniform Lifetime Table”. If you are in a company retirement plan and continue to work beyond age 72, then you may delay your RMD until you retire unless you own more than 5% of the company, in which case you must begin your retirement plan RMDs at age 72 regardless of whether or not you are retired.

Following is an example of how the RMD is calculated. Opie Taylor turns 72 this year. His IRA value on December 31, 2020 was $500,000. The IRS’s Uniform Lifetime Table shows Opie’s divisor is 25.6. Opie’s account value of $500,000 divided by 25.6 is $19,531.25. Opie is required to withdraw at least $19,531.25 from his IRA by April 1st of the year following his 72nd birthday for his first RMD. For subsequent year RMDs, he must withdraw the amount before December 31st. It is only with the first RMD that the account holder may choose to wait until April 1st of the year following their 72nd birthday. We generally recommend that retirement account owners do not wait until the following year to take their first RMD since that means they will need to take two RMDs in that same year (their first RMD by April 1st of the year following their 72nd birthday and their current year RMD before December 31st of the same year) which may result in a fairly significant tax bill since RMDs are taxed at your ordinary income tax rate.

It is important to consult the IRS Uniform Life Table to determine the correct amount that must be withdrawn from your IRA each year since the table reduces the divisor for subsequent years. Your IRA account custodian is required to calculate your RMD for you, and some will automatically distribute it to you on an annual basis if you request that they set it up that way. However, it is easy to miss an email or notice in the mail from your account custodian that tells you it’s time to take your RMD. Therefore, it is important to know the timing and amount of your RMD and arrange to have it distributed from your IRA before the end of the year.

Retirement plan participants and IRA owners, including owners of SEP IRAs and SIMPLE IRAs, are responsible for taking the correct amount of RMDs before the deadline each year from their accounts, and they face stiff penalties for failure to take RMDs. In fact, the penalty for not taking your RMD is currently 50% of the amount that you were required to take. That’s a hefty penalty!

You might ask, “Is there anything that I can do to avoid taking my RMD and being required to pay tax on the distribution?” The answer is generally, “No.” While you were employed and socking away savings in your IRA or company retirement plan, your account was growing tax deferred. The key words here are “tax deferred”, not tax free. You were not required to pay income taxes on the interest, dividends, or capital growth that the investments in your IRA generated over the years. Once you reach the magic age of 72, Uncle Sam is ready to start collecting some of the taxes that you have deferred. Most folks are retired by this point and no longer generating taxable wages. So, ideally, their income tax bracket will be lower and their RMD will be taxed at a lower rate than when they were employed.

While you cannot avoid taking RMDs from your retirement account, there is a way to reduce your tax bill if you are charitably inclined. Qualified Charitable Distributions, or “QCDs”, are distributions from your IRA that go directly to 501(c)(3) charitable organizations. The charitable distributions can be used by IRA owners who must take an RMD to directly offset the amount of their RMD up to $100,000.

For example, at the beginning of the year Jan Brady, who just turned 72, has been thinking about her RMD. She plans to use some of it toward her favorite charity, Saving Face. Jan’s RMD this year is $20,000. She will donate $10,000 directly from her IRA to Saving Face. For tax purposes, Jan will only be responsible for $10,000 of RMD income because she reduced her $20,000 RMD by the $10,000 charitable gift.

Keep in mind that the QCD must be distributed directly from the IRA to the charitable organization(s) before the total amount of the annual RMD is taken in order to avoid tax on the RMD. So, if you plan charitable gifting from your RMD this year, then be careful not to withdraw your RMD until you’ve made the QCDs or they will not reduce your RMD, and thus, your taxable income. For example, Jan Brady’s sister Marcia is driving a sporty Mazda Miata convertible. Jan thinks, “Marcia, Marcia, Marcia, gets all of the attention!” Before making a charitable donation from her IRA, Jan decides to use her $20,000 IRA RMD to purchase a vintage AMC Gremlin. Because Jan has already satisfied her 2021 RMD with the $20,000 withdrawal, the QCD to Saving Face made after her RMD has been distributed will not offset any of the income from her RMD for tax purposes. Jan may still make the donation to Saving Face with a QCD from her IRA and the distribution will not be taxable to her, but it will not offset her RMD.

With careful charitable gift planning before taking your RMD, you can reduce the tax burden caused by your annual IRA withdrawal. If you have questions about RMDs, QCDs, Roth conversions, or other issues affecting your financial situation, we welcome the opportunity to discuss them with you. In the meantime, whether you are meandering in your Miata, or goosing the gas in your Gremlin, enjoy the return of warmer spring days!