Did you know that, once you turn age 70½, you must start taking mandatory annual withdrawals from your traditional IRAs, including any simplified employee pension (SEP) accounts and SIMPLE IRAs that you set up as a small business owner?
These mandatory IRA payouts are called required minimum distributions (RMDs). And there's a stiff penalty if you fail to take timely distributions.
Unfortunately, taking RMDs also will cause you to report additional taxable income on your federal income tax return. This will increase your federal income tax liability and possibly your state income tax liability, if applicable. Here are the rules regarding RMDs and a tax-smart strategy for meeting your RMD obligations.
If You Hit the "Magic Age" in 2016
Your first RMD must be taken by no later than April 1 of the year after the year you turn 70½. So, if you hit the "magic age" last year, the April 1 deadline for you to take your initial RMD is almost here. Remember, however, that this initial RMD is for the 2016 tax year, even though you still don't have to withdraw it until April 1, 2017.
If you fail to withdraw the full RMD amount by April 1, 2017, the IRS will charge you a penalty equal to 50% of the shortfall (the difference between the RMD amount you should have taken for the 2016 tax year and the amount you withdrew through April 1, 2017).
If you already took one or more traditional IRA withdrawals last year that equaled or exceeded the amount of your RMD for the 2016 tax year, you can ignore the April 1 RMD deadline. Just remember to take your second RMD, for the 2017 tax year, by December 31, 2017. The calendar year-end deadline applies for all future years too.
For the 2016 calendar year, the RMD amount that you must withdraw by April 1, 2017, if you turned 70½ in 2016 — or were required to withdraw by December 31, 2016, if you previously turned 70½ — equals the combined balance of all your traditional IRAs (including any SEP accounts and SIMPLE IRAs) as of December 31, 2015, divided by a life-expectancy factor based on your age as of December 31, 2016.
You can choose to withdraw that amount from any one of your traditional IRAs or from several IRAs. If your spouse also has one or more traditional IRAs set up in his or her own name, the RMD rules apply separately to those accounts. So, if your spouse turned 70½ last year, he or she may need to heed the April 1 deadline, too.
Important note: Roth IRAs established in your name are exempt from the RMD rules for as long as you live. So, you can continue to invest the full amount of your Roth IRA balances and continue to produce tax-free income throughout your lifetime.
Consider a Tax-Free Alternative
Instead of taking taxable RMDs, individuals who have reached age 70½ can make annual cash donations to IRS-approved charities directly from their IRAs. These so-called qualified charitable distributions (QCDs) come out of your traditional IRA free from federal income tax. (Other IRA distributions, including RMDs, are generally at least partially taxable.)
Unlike cash donations to charities, you can't claim itemized deductions for QCDs. However, the tax-free treatment of QCDs equates to a 100% deduction, because you'll never be taxed on those amounts.
As an added bonus, a QCD coming from a traditional IRA counts as a distribution for purposes of complying with the RMD rules. Therefore, if you turned 70½ last year and haven't yet taken your RMD for last year, you can arrange for one or more QCDs between now and April 1, 2017, to meet all or part of your RMD obligation for the 2016 tax year. In other words, you can substitute one or more tax-free QCDs for the RMD that you would otherwise have to take by April 1, 2017, and pay taxes on.
Following QCD Guidelines
A QCD must meet the following requirements:
It can't occur before the IRA owner turns 70½.
It must meet the requirements for a 100% deductible donation under the itemized charitable deduction rules. If you receive any benefits that would be subtracted from a donation under the normal charitable deduction rules — such as tickets to a sporting or social event — the IRA distribution isn't considered a QCD, and you'll owe taxes on it.
In addition, there's a $100,000 limit on total QCDs for the year. But if you and your spouse both own IRAs, you're each entitled to a separate $100,000 annual QCD limit.
Individuals who are 70½ or older should be aware of the RMD rules and the deadlines that apply in the year they turn 70½ and beyond. If you have questions or want more information about RMDs, or you're interested in taking advantage of the QCD option, contact your investment or tax advisor.
PKS Investment Advisors LLC is an independent investment advisor and financial planning firm with offices in Salisbury, Ocean City and Lewes – specializing in estate planning, retirement planning, wealth management, investment strategies, business planning, 401k plans, fiduciary services and tax management through PKS & Company, P.A.