Paying Back Uncle Sam through Required Minimum Distributions

Posted Nov 4, 2009 | Jason D. Landers

We knew the day would come when we would have to pay back Uncle Sam for allowing us to save for years in our retirement accounts without paying taxes. We’ve been putting money pre-tax into our 401(k)s and IRAs and now he wants his share. I am talking about “Required Minimum Distributions”—mandatory withdrawals that trigger income tax on tax-deferred accounts beginning at age 70 ½. In this article, I will address several important points regarding distributions from retirement plans.

When do I have to start taking distributions from my account? This is a common question among retirees and the answer is different depending on the situation. Let’s first talk about IRA accounts. The Required Beginning Date (RBD) for Traditional IRA accounts, not Roth IRAs, is April 1st in the year following the account holder turning 70 ½. This date has nothing to do with whether the account holder is still working or not. Things change when we talk about employer sponsored plans such as 401(k)s, profit sharing plans, and Thrift Savings Accounts. The RBD date is April 1st following the year in which the account holder has the later of the two items below occur:

Attain age 70 ½ or;
The year in which the account holder retires from service

When taking Required Minimum Distributions, it is important to know the different methods to calculate exactly how much a person has to take from his or her account to satisfy the annual requirement. For account holders whose spouse is less than 10 years younger or if the spouse is not the sole beneficiary, the most likely table to be used in calculating the RMD is the Uniform Lifetime Table. For account holders whose spouse is more than 10 years younger, the likely choice would be the Joint & Last Survivor Table. Let’s look at an example:

For a 72 year old who has a year-end value in his Traditional IRA of $750,000 and his wife is age 65, using the Uniform Lifetime Table, the Required Minimum Distribution for that year would be $29,296.88

$750,000 / 25.6 = $29,296.88 RMD
(25.6 represents the distribution period based on life expectancy tables)

Using the correct table to calculate your Required Minimum Distributions is important, but it is also worth mentioning that you should take into consideration all IRA balances when calculating the annual withdrawal. Any balances left out could be imposed a 50% excise penalty tax on the amount that should have been taken out. By way of the Worker, Retiree, and Employer Recovery Act of 2008 (H.R. 7327) (the “WRER Act”), Required Minimum Distributions for 2009 are not required. This provision is for only the 2009 tax year, and mandatory distributions are scheduled to return in 2010.

One of the biggest negatives that investors have in taking RMDs is to withdraw money that they do not need for income purposes, and then having to pay taxes on the distribution. There are a few strategies to increase the effectiveness of your distributions if the income is not relied upon.

For legacy planning purposes, one strategy that can be utilized to take advantage of unused required distributions from retirement accounts is creating an Irrevocable Life Insurance Trust (ILIT). Distributions from an IRA or 401(k) are taxed upon withdrawal, but those monies could then be used as premiums to fund the ILIT. Upon the death of the insured, the life insurance policy would pay out to the trust and be a tax-free benefit to the beneficiaries. This planning strategy is one that could create liquidity to pay estate taxes if applicable.

Another strategy for RMD distributions is to help your loved ones by funding a college savings account such as a Section 529 plan. Although your distribution from the IRA will still be taxed as ordinary income, the 529 assets will grow tax-free for your beneficiary. However, for the account to reap the benefits of tax-free growth, the future distributions from the account must be used for higher education expenses. It is also important to note that 529 plans allow for 5 year forward gifting, meaning that they are not limited to the annual gift tax exclusion limits ($13,000 for 2009) This is provided that you do not make any other taxable gifts over that time period.

Every family has a different set of circumstances; therefore it is important to consult your financial professional when considering any of the above mentioned strategies.

Note: The techniques and strategies above are intended to provide accurate information regarding the subjects covered; however, they are furnished with the understanding that neither BlueCreek Investment Partners, LLC nor the author are engaged in rendering legal, or tax professional advice or counsel. BlueCreek encourages the reader to seek competent professional counsel to address any legal or tax issues that may arise.