Tax Law Insights

Most people are familiar with the significant income tax benefits of contributing to a qualified retirement plan such as a 401(k) plan, or individual retirement accounts (IRAs) and the deferral of the income earned by the retirement account is a material income benefit. However, as we have previously discussed, there are very specific rules that require annual distributions from these plans. Unless certain limited exceptions apply, these distributions must begin by April 1 following the year in which the employee attains age 70 1/2. These annual distributions are typically referred to as required minimum distributions or RMDs. This article will address one of the complexities confronting a taxpayer who has must begin taking RMDs which is whether or not to defer the first distribution from the qualified plan or IRA to the required beginning date.

As a general rule, retirees who turn age 70 1/2 and have assets in their employer-sponsored qualified retirement plan or in a traditional individual retirement account (IRA) are generally required to take their first distribution no later than the required beginning date, April 1 of the following tax year. Although the taxpayer is permitted to defer the distribution of the RMD to the required beginning date, the RMD relates to the prior tax year.

For example, suppose a taxpayer who has an IRA attains age 70 1/2 in 2015. The taxpayer has two options. One option is to defer the distribution until the required beginning date of April 1, 2016. The taxpayer will include the April 1, 2016 withdrawal in income in 2016 and this initial distribution will satisfy the 2015 RMD. For the 2016 calendar year, the taxpayer must still withdraw his 2016 RMD by December 31, 2016. The result is that the taxpayer must take both distributions (and paying the applicable taxes) in the same 2016 tax year. This bunching of income can result in an increased income tax liability. The other alternative is for the taxpayer to elect to take the first RMD by December 31, 2015 and not defer the distribution until the required beginning date of April 1, 2016. The taxpayer will include the 2015 withdrawal in income in 2015. For 2016, the taxpayer must withdraw his RMD by December 31, 2016. By taking the first distribution into income in the year the taxpayer attain age 701/2, 2015 in this example, the taxpayer avoids the bunching of income that will necessarily occur if distributions were deferred until the required beginning date.

Which option is best? That depends very much on the taxpayer's income tax bracket, other income, and other income tax deductions and simply the need for the income. The issue here is to be aware that you have some choice in this case and simply postponing the distribution until the latest date in this case might not be prudent.

Given the complexity of these rules there is no doubt some desire to make a withdrawal well in excess of the RMD and only deal with this issue periodically. Unfortunately it is not possible to pre-fund or postpone distributions of an RMD. Only RMDs can satisfy the RMD distribution requirement. Distributions prior to attaining age 701/2 do not count against the RMD requirement and distributions greater than the RMD in one calendar year cannot be carried forward to offset against the RMD in a subsequent year. Thus if the RMD for 2016 is $10,000 the fact that the taxpayer withdrew $100,000 in years prior to 2016 will not avoid the 50% excise tax. Similarly, suppose the taxpayer commences distributions in 2015 and withdraws $ 5,000 more than the $10,000 RMD for each of the calendar years 2015, 2016 and 2017. Assume the RMD for 2018 is $10,000 but no withdrawal is made. The prior excess distributions would will not avoid the 50% excise tax on the RMD for 2018.

These rules related to RMDs change yet again upon the death of the taxpayer. Depending upon the type of account, the beneficiary, and the age of participant at death, each will affect the RMD and lead to a different result.

As noted above, one of the advantages of the qualified retirement plan or IRA is that the taxpayer has significant flexibility and control on the timing of the receipt of income from these accounts. However, this flexibility is not unlimited and RMDs must begin no later than the April 1 following the year in which the employee attains age 70 1/2, unless certain limited exceptions apply. Failure to the make these distributions may result in a 50% excise tax penalty. Although deferring distributions to the required beginning date is permitted this can result in a bunching of income in a single tax year.