If you have one or more traditional IRAs set up in your name and will be age 70 1/2 or older at year end, you must comply with the so-called required minimum distribution (RMD) rules or face a stiff penalty. These rules force older account owners to take annual withdrawals from their IRAs and pay the resulting extra federal income tax. The same rules also apply to simplified employee pension (SEP) accounts and SIMPLE-IRAs, because they count as traditional IRAs for this purpose. (Thankfully, if you own one or more Roth IRAs, those accounts are exempt from the RMD rules for as long as you live.)

Table of Life Expectancy Divisors for IRA Owners

This table lists the IRS-provided life expectancy divisors generally used to calculate RMDs for IRA owners. To find the appropriate divisor, use your age at the end of the year for which you are calculating the RMD. (Do not use this table if you are the beneficiary of a deceased person's IRA. In that case, you must use different life expectancy divisors to calculate annual RMDs from the inherited account. Consult with your tax adviser for details.)

Age

Divisor

70

27.4

71

26.5

72

25.6

73

24.7

74

23.8

75

22.9

76

22.0

77

21.2

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20.3

79

19.5

80

18.7

81

17.9

82

17.1

83

16.3

84

15.5

85

14.8

86

14.1

87

13.4

88

12.7

89

12.0

90

11.4

91

10.8

92

10.2

93

 9.6

94

 9.1

95

 8.6

96

 8.1

97

 7.6

98

 7.1

99

 6.7

100

 6.3

Exception: Do not use this table to calculate RMDs if your spouse is designated as the sole beneficiary of your account, and he or she is more than 10 years younger than you. In that case, use the bigger life expectancy divisors from Table II of Appendix C in IRS Publication 590 (available at www.irs.gov). The bigger divisors result in smaller annual RMDs, which is helpful if you want to obtain maximum tax deferral from your IRA.

If you think the RMD rules are just a minor nuisance that you can ignore, think again! If you fail to withdraw at least the annual RMD amount, the IRS can assess a 50 percent penalty on the shortfall (the difference between the RMD amount you should have withdrawn for the year and the actual amount you did withdraw). It's one of the harshest tax penalties on the books.

Here's what you need to know about the RMD rules and what you may need to do before year end to stay out of the penalty box.

Required Minimum Distribution Basics

Your first RMD is for the year you turn 70 1/2Then, you must take another RMD for each succeeding year for as long as you live or as long as you have a balance in one or more traditional IRAs.

Your annual RMD amount equals the total of your traditional IRA balances (including any SEP or SIMPLE-IRA balances) as of December 31 of the previous year divided by a life expectancy divisor provided by the IRS.

The RMD amount must be recalculated annually, because your IRA balance as of the end of the previous year is a moving target, and so is the life expectancy divisor. As you grow older, the life expectancy divisors get smaller and smaller, which means the annual RMDs become a bigger and bigger proportion of the IRA balance. See the SIDEBAR for the table of life expectancy divisors that most IRA owners should use.

Note: In January of each year, your IRA custodian or trustee is supposed to notify you if an RMD must be taken for that year and tell you the amount. You may be able to arrange to have that amount distributed to you automatically in a lump sum or monthly or quarterly installments. However, don't take anything for granted. By knowing how the RMD rules work and by taking personal responsibility for complying with them, you can be certain that you will not get hit with the 50 penalty penalty.

If You Turn 70 1/2 This Year

As we said earlier, your initial RMD is for the year you turn age 70 1/2. Thanks to a special timing rule that only applies to that initial RMD, you have two options for when to withdraw it.

Option No. 1: Take Initial RMD before Year End.The first option is to take the initial RMD by December 31 of the year you turn the magic age. So if you turn 70 1/2, this year and choose this option, you should take your initial RMD by no later than December 31, 2012.

Example 1: You reached age 70 1/2 this year. For purposes of this example, let's assume you'll not yet be 71 as of December 31, 2012. To calculate your initial RMD, divide the combined balance of all your traditional IRAs as of December 31, 2011 by 27.4, which is the life expectancy divisor for a 70-year-old from the table in the right-hand box.

Your combined IRA balance as of December 31, 2011 was $300,000. Your initial RMD, which is for the 2012 tax year, equals $10,949 ($300,000/27.4). Withdraw at least that amount by December 31, 2012. If you've already taken some IRA withdrawals earlier this year, they offset the amount you must take out by the end of this year.

Your second RMD, which will be for the 2013 tax year, must be withdrawn by no later than December 31, 2013. The amount will equal your December 31, 2012 IRA balance divided by 26.5, which is the life expectancy divisor for a 71-year-old from the table. And so on for subsequent years.

If you follow this drill, you won't get hurt by the 50 percent penalty for not complying with the RMD rules.

Option No. 2: Take Initial RMD Next Year. The other option is to take your initial RMD by no later than April 1 of next year (the year after the year you turn 70 1/2). However, if you choose this option, you must withdraw your first and second RMDs next year.

Example 2: Same basic facts as in Example 1, but this time you choose to withdraw your initial RMD next year, by the April 1, 2013 deadline.

To calculate that initial RMD (which is actually for your 2012 tax year), divide the combined balance of all traditional IRAs as of December 31, 2011 by 27.4 (the life expectancy divisor for a 70-year-old from the table). Say your combined IRA balance as of December 31, 2011 was $300,000. Your initial RMD is $10,949 ($300,000/27.4). Withdraw at least that amount by April 1, 2013.

You must withdraw your second RMD (for your 2013 tax year) by no later than December 31, 2013. The amount will equal your December 31, 2012 IRA balance divided by 26.5, which is the life expectancy divisor for a 71-year-old.

You must take your third RMD -- which will be for your 2014 tax year -- by no later than December 31, 2014. The amount will equal your December 31, 2013 IRA balance divided by 25.6, which is the life expectancy divisor for a 72-year-old from the table.

And so on for subsequent years.

Why Option No. 2 May Not Be the Tax-Smart Choice. As you can see from Example 2, choosing to defer your initial RMD until next year will cause a double-dip of extra taxable RMD income in 2013. That could be a bad idea for several reasons.

  • The double dip could push you into a higher 2013 tax bracket.
  • Your 2013 tax bracket may be higher due to the scheduled expiration of the Bush tax cuts. If so, a double dip of RMD income next year could be taxed at higher rates than if you take a single dip this year and another single dip next year.
  • Taking a double dip in 2013 could also increase your exposure to the new 3.8 percent Medicare surtax on net investment income. While the surtax will only affect higher-income taxpayers, taking two RMDs in 2013 could cause you to owe more for the surtax than if you take one this year and another one next year.

Bottom Line: For the preceding reasons, taking your initial RMD this year (Option 1) may be advisable even though you would be taxed on the amount sooner than if you take the initial RMD next year (Option 2). Work with your tax advisor to factor this issue into your overall year end tax planning strategy.

If You Turned 70 1/2 before this Year

If you turned 70 1/2 in 2011 or earlier, your RMD situation is pretty simple. Withdraw at least the RMD amount for your 2012 tax year by no later than December 31, 2012. To calculate the amount, divide the combined balance of all your traditional IRAs as of December 31, 2011 by the life expectancy divisor from the table, based on your age as of December 31, 2012.

If You Have Multiple IRAs

As explained earlier, when you own several traditional IRAs (including any SEP accounts or SIMPLE-IRAs), you must withdraw at least the annual RMD amount based on the combined balance of all those accounts. However, there's no requirement to actually withdraw money from any specific account. As long as you withdraw the proper RMD in total, you can take the money out of as few or as many accounts as you wish.  

Beneficiary of a Deceased Individual's Tax-Favored Account

If you are the beneficiary of a deceased person's traditional IRA, Roth IRA, or qualified retirement plan account (such as a 401(k) account), you must comply with a separate set of RMD rules for inherited accounts. Depending on the circumstances, it may be necessary to withdraw an RMD by as early as December 31, 2012 in order to avoid the 50 percent penalty. Consult with your tax adviser to determine what must be done this year, if anything.

Conclusion

Complying with the RMD rules is an important tax issue for traditional IRA owners who are age 70 1/2 and older and for beneficiaries of inherited tax-favored retirement accounts. You may need to take action by year end to avoid the 50 percent penalty for noncompliance.

If you turn 70 1/2 this year, you may be better off withdrawing your initial RMD by December 31, 2012 instead of putting it off until next year.

If you have questions about RMDs or want additional information, contact your advisor.

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