Becoming a septuagenarian is a milestone in itself, but when you turn 72 it also means that soon the IRS will likely expect you to start cashing out your tax-deferred retirement savings that you may have spent decades building up.

If you don’t start taking what are called required minimum distributions (RMDs) from your non-Roth individual retirement account (IRA) or 401(k) accounts and pay taxes on the withdrawals, you will face a 50 percent penalty on what should have been withdrawn but wasn’t. But more than this, how you structure these distributions can have a profound effect on your own retirement and on what you leave your heirs.

Congress created the rules governing the minimum distribution of retirement plan funds to encourage saving for retirement and to allow retirement assets to build up tax-free during the plan owner’s working years. You do not pay tax on income you put into a tax-deferred retirement plan when earned or on investment income or gains on the account itself. However, the funds you withdraw upon retirement are treated as taxable income in the year you take the distribution. And if your children withdraw the funds from a tax-deferred account that they inherit from you, they will be taxed on such distributions at their income tax rates.

Not everyone with a retirement account must take RMDs, however. Usually, employees who are still working can, if their plan allows, wait until April 1 of the year after they retire to start receiving these distributions, as long as the employee doesn’t own at least five percent of the company.  (You still have to take RMDs from SEP or SIMPLE plans, although you can continue contributing to them as well.) Also, funds up to $125,000 invested in a qualifying longevity annuity contract (QLAC) are not counted in calculating your regular RMDs and distributions are not required until age 85.

When to Start the Withdrawals?

The first decision 72-year-olds have to make is when to begin their RMDs.  Ordinarily, your RMD must be made by December 31 of each year.  But recognizing that people may need some extra time to adjust to this new landscape, the IRS allows you to defer your first RMD until April 1 of the year following the year you turn 72.

But waiting as long as possible may not be in your interest. If you delay until April 1 of the year after you turn 72, you could have a hefty tax bite because you would have to take your second year distribution by December 31 of the same year. This additional income could push you into a higher tax bracket for that year and also affect the tax that might be due on your Social Security benefits and maybe even increase your Medicare tax for the following year if your income rises above $200,000 (for single filers; 2022 figure).

Making the Calculation

You must withdraw a small percentage of your tax-advantaged retirement savings each year after age 72. The exact amount for a year is determined by dividing the fair market value of your retirement account(s) as of the previous year’s end by the applicable distribution period. A chart gives your distribution period in years. If, for example, you had $100,000 in a retirement account on December 31 of last year and you were 73 as of that date, you would have to withdraw $4,049 from the account by the end of this year ($100,000 divided by your distribution period of 24.7 years).

The distribution period is different if the sole beneficiary of your IRA is your spouse and he or she is more than 10 years your junior.  In this case, consult the “Joint Life and Last Survivor Expectancy” table in the Appendix of the IRS’s Publication 590. To see this publication, go to: https://www.irs.gov/pub/irs-pdf/p590b.pdf.

Also, just because you missed a required withdrawal or didn’t withdraw enough doesn’t mean you’ll automatically get hit with the 50 percent penalty. You can ask the IRS to waive the penalty by filing Form 5329 with your tax return, saying that you were confused or had poor financial advice.

Advance Planning Helps

Planning in advance can help you avoid ending up in a higher tax bracket or paying higher Social Security or Medicare taxes once you start taking your RMDs. One strategy is to convert some of your retirement funds to Roth IRAs in years prior to turning 70. The RMD rules do not apply to the Roth IRA owner, although you will pay taxes when you convert. The ideal time to convert would be after you retire and may be in a lower tax bracket. You can also, of course, start making withdrawals from tax-deferred accounts early, before you are required to do so, as long as you have reached at least age 59 ½.

Another technique is to make a qualified charitable distribution (QCD). Investors aged 72 or older may transfer as much as $100,000 a year from an IRA directly to a charity without having it count as taxable income. A QCD can be used to meet part or all of an RMD obligation (as long as it’s less than $100,000) and no income tax will be due on the withdrawal.

Managing your RMDs can be a tricky proposition, particularly for those with multiple accounts. You want to avoid pushing yourself into a higher tax bracket, but you also don’t want to under-withdraw and face a 50 percent penalty, or miscalculate your year-end account balance because your account custodian wasn’t aware of current year recharacterizations and conversions. For these reasons, it’s a good idea to consult with a financial advisor or your elder law attorney well before crossing the threshold into RMD land.

The rules around required minimum distributions are confusing, and it’s easy to slip up. Fortunately, if you do make a mistake, there are steps you can take to fix the error and possibly avoid a stiff penalty.

Fixing Required Minimum Distribution Mistakes

If you have a tax-deferred retirement plan such as a traditional IRA or 401(k), you are required to begin taking distributions once you reach a certain age, with the withdrawn money taxed at your then-current tax rate.  If you miss a withdrawal or take less than you were required to, you must pay a 50 percent excise tax on the amount that should have been distributed but was not.

1. Take the correct distribution

It can be easy to miss a distribution or not withdraw the correct amount. If you make a mistake, the first step is to quickly correct the mistake and take the correct distribution. If you missed more than one distribution – either from multiple years or because you withdrew from several different accounts in the same year — it is better to take each distribution separately and for exactly the amount of the shortfall.

2.  File IRS Form

The next step is to file IRS form 5329. If you have more than one missed distribution, you can include them on one form as long as they all occurred in the same year. If you missed distributions in multiple years, you need to file a separate form for each year. And married couples who both miss a distribution need to each file their own forms. The form can be tricky, so follow the instructions closely to make sure you correctly fill it out.  You should also consider contacting a CPA to ensure that you have completed the form correctly.

3.  Submit a letter

In addition to completing form 5329, you should submit a letter, explaining why you missed the distribution and informing the IRS that you have now made the correct distributions. There is no clear definition of what the IRS will consider a reasonable explanation for missing a distribution. If the IRS does not waive the penalty, it will send you a notice.

For more detailed information on how to correct an RMD mistake, click here.

The Stinson Law Firm has years of experience advising clients with their estate and asset protection planning needs.  Please contact us at 317-622-8181 to schedule an appointment to create or review your plan today.

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