When it comes to retirement savings plans, the tax code is your friend. The government provides incentives for you to stash money in special tax-deferred accounts, such as IRAs and employer-sponsored 401(k)s. Money saved in these accounts grows sheltered from taxation, including any dividends, interest and capital gains that it earns.
But at the magic age of 70 ½, all that changes. That's when the IRS springs a trap for everyone who has been programmed to save all of their working careers. They now must begin taking withdrawals from these accounts.
The sole purpose is to make people deplete their savings to generate tax revenue for the government. This perverse requirement goes by the name of "required minimum distribution" (RMD). Here's a basic rundown of how these rules work.
First, don't think you can fly under the radar, not take a distribution and have it go unnoticed by the IRS. Banks, brokerages and other financial firms that serve as the required trustees and custodians for retirement accounts must report to the IRS annually the amount of the RMD for each taxpayer and for each year a distribution is required.
If you don't follow these requirements, it can really cost you, resulting in a harsh 50 percent excise tax on the amount of the distribution that's late or insufficient.
The general rule is that if you have a balance in an IRA, you must begin distributions from it no later than April 1 of the year following the year you turn age 70 ½. Those who turn 70 ½ in 2016 can wait until April 1, 2017 to take their first distribution.
But it might be wise to take the first distribution this year because if you wait until the following year, you'll also be required to take the distribution for 2017 before year-end, causing you to take two distributions in 2017.
Doing this can raise your taxable income and increase the tax you owe on Social Security; it could even disqualify you from claiming some itemized deductions. Check with your tax or financial adviser to see which tax year is best for you to take the first RMD.
The IRS calculates the minimum amount you must withdraw using a factor from the Uniform Lifetime Table, which is specified in IRS Publication 590. The account value as of the most recent year-end is divided by the factor from the table that coincides with your current age.
For example, the factor for individuals age 70 is 27.4. So if you're 70 in 2016 with IRA whose value is $250,000 on Dec. 31, 2015, your first-year RMD is $9,124. This is about 3.6 percent of your year-end balance.
Each year, the divisor gets smaller, resulting in an increased percentage that you must withdraw. Most financial firms offer a service that will calculate the annual distribution, withhold applicable taxes and deposit the remaining amount into an account of your choosing. I strongly advise signing up for such a service.
A special rule allows people who continue to work to put off distributions from their employer's retirement plans. If you're still working and have a balance in your employer's retirement plan and aren't an owner of the business that maintains the plan (a "5 percent owner"), you can wait to start withdrawals until the later of April 1 following the year in which you reach age 70 ½ or when you retire.
If you have multiple IRAs, an RMD must be calculated separately for each one. However, these amounts may then be totaled and taken from any one or more of the IRAs.
If you have a more than one account in an employer's retirement plan, you must calculate and withdraw an RMD from each plan. Aggregation isn't permitted.