RMDs and IRAs: What to Consider from a Tax Perspective

IRAs are popular retirement savings vehicles, largely because they offer tax advantages to individual Houston investors. Those advantages differ depending on the IRA. Traditional IRAs defer tax on any money or assets invested until you take distributions upon retirement. Roth IRAs tax income into the account upon transfer at your current tax bracket, and no additional tax is taken at distribution. This matters when you consider that any growth on your investments will be taxed accordingly in a traditional IRA, but not so in a ROTH.

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Another worthwhile consideration with traditional IRAs is the required minimum distributions (RMDs). Here, we’ll address what RMDs are and how they may affect a Houston individual’s tax planning strategy.

What are Required Minimum Distributions and When are They Required?

Beginning at an age specified by the IRS (and adjusted based on current life expectancy), owners of a traditional IRA account must begin taking RMDs. Currently, the age one must begin taking RMDs is 72 – or 73 if the taxpayer turned 72 after December 31, 2022.

RMDs are a check put in place by the IRS to prevent people from using their traditional IRA as a way to avoid taxes. Because traditional IRAs provide upfront tax benefits in the form of a deduction, taxpayers might avoid paying taxes on their IRA earnings if there wasn’t a requirement in place to prevent this.

RMDs are that incentive. If required minimum distributions are not withdrawn from an IRA account, an additional excise tax will be levied against the account. Starting in 2023, this tax is equal to 25 percent of the RMD not removed from the account. If the issue is corrected within two years, the tax may drop to 10 percent.

How to Calculate Required Minimum Distributions

Calculating RMDs can be complex, as taxpayers must be aware of what’s in their IRA account to accurately assess their RMD. The math isn’t too difficult, though, and it looks like this:

Value of the IRA account (as of December 31 of the preceding year), divided by a “distribution factor” that’s published on its Uniform Lifetime Table (Publication 590-B). Distribution factors range from 1.9 to 27.4, depending on the taxpayer’s age. As a taxpayer ages, their distribution factor drops. In other words, as the taxpayer gets older, their RMD increases.

For example, at age 78, a taxpayer’s distribution factor is 22 – derived from the IRS’s Uniform Lifetime Table. A 78-year-old has a traditional IRA that, as of December 31 of the previous tax year, was worth $100,000.

The RMD, in this example, is $100,000 divided by 22. That comes out to $4,545. So, this taxpayer would need to withdraw at least $4,545 out of their traditional IRA to avoid paying an excise penalty.

It is worth noting that RMDs are calculated for each account and must be withdrawn from each account to avoid penalties.

Want to Avoid RMDs? Consider Investing in a Roth IRA

The surest way to avoid RMDs is to invest in a Roth IRA instead. Roth IRAs provide their tax benefits upon withdrawal, not investment. As such, there is no need for the IRS to pressure Roth IRA holders into paying taxes on account funds as they’ve already been paid for.

The tradeoff is no immediate tax deduction, but many people are okay with this, as they assume their income bracket at retirement will be lower.

Taxpayers have the option to transfer, convert, or “rollover” their traditional IRA funds to a Roth IRA to avoid paying RMDs, but one must be aware of the tax consequences of this. Taxes must be paid on traditional IRA distributions into a ROTH account, and these distributions may temporarily kick an individual into a higher tax bracket that year.

A tax expert can help their clients make this traditional-to-Roth transition without overwhelming them with additional tax burdens.

When an IRA is Inherited: How RMD Rules are Applied

RMD rules also apply to inherited IRAs, as defined in the SECURE and SECURE 2.0 Act. These rules depend on whether there is a named beneficiary attached to the IRA, and what the beneficiary’s age is. Here are some common scenarios:

• If the deceased spouse died before RMDs were required – One of the most common situations is for a spouse to inherit an IRA following their husband or wife’s death.

  If the spouse is the only beneficiary named in the IRA, they may transfer the IRA assets to their own IRA, or they may open an inherited IRA in their own name. If the assets are transferred, the surviving spouse’s age is what’s considered for early withdrawal and RMD purposes.

  If the assets are included in a newly opened IRA in the spouse’s name, RMDs start the year when the decedent would’ve turned 73 (so, the year RMDs would have kicked in for the deceased spouse) or on December 31 of the year after the decedent passed away. The later of these two dates is used for RMD purposes.

  The above rules apply only if the surviving spouse chooses to take distributions using their life expectancy as the guide. There are other options, though. For example, an inherited IRA in the beneficiary’s name may be liquidated immediately as a lump sum – and taxes will need to be paid out in the process. Or the beneficiary may opt into the 10-year rule, which requires the account to be completely liquidated at the 10-year mark following the decedent’s death. In this instance, distributions can be taken out right away without an early withdrawal penalty.

• If the deceased spouse died after RMDs were required – If the decedent was old enough that IRA distributions were required, those requirements are passed on to the inheriting spouse.

  Inheriting spouses may transfer the IRA’s assets to their own IRA, or they may open up an inherited IRA in their own name. In the former’s case, the spouse must be the only named beneficiary. If an inherited IRA is opened in the spouse’s name, they may name additional beneficiaries for the account.

  However, RMDs are required and must be taken out starting the year of the decedent’s death if they would have needed to take an RMD for themselves.

  Alternatively, the surviving spouse may liquidate the IRA. Again, though, taxes must be paid on the assets immediately, and this may kick the inheriting spouse into a higher tax bracket for that year.

RMDs and IRAs Can Be Complex, So Work with a Reputable Tax Professional

As you can see, RMDs are a tricky subject for IRA holders. It’s even trickier when an IRA is passed to a beneficiary. If RMDs aren’t taken out on time, there may be severe penalties for failing to do so, but distributions can also move a taxpayer into a higher tax bracket – and burden them with additional tax obligations in the process.

There are a lot of moving parts where IRAs and RMDs are concerned, so it’s highly recommended that IRA holders consult with a trusted tax professional before taking distributions or naming beneficiaries. An experienced Houston tax expert can help their clients plan out their distribution schedule and ensure their tax burden remains minimal when handling account assets.

By Harold "Hap" May, P.C. on October 6, 2023   /   Blog, The Legal Play Podcast   /   Leave a comment