Avoid Impact of Double Distribution: First and Second Required Minimum Distributions

Avoid Impact of Double Distribution: First and Second Required Minimum Distributions

Presented by Jared Daniel of Wealth Guardian Group

What is it?

You are 70½ this year. Over the years, you've accumulated funds in a traditional IRA or employer-sponsored retirement plan and those funds have been growing tax deferred. But tax deferral doesn't last forever with a traditional IRA or a retirement plan. At some point, the government requires that income tax be paid on those funds, and that's where required minimum distributions come into play. Unless an exception applies, income tax is due when distributions are made.

You know (because you've read about the required minimum distribution (RMD) rule) that you have to start taking minimum distributions from your IRA or employer plan no later than April 1 of the year after reaching age 70½. When you have to start taking distributions is known as the required beginning date (RBD). You have a choice of taking your first required distribution either (1) in the year you reach age 70½ or (2) by April 1 of the following year. Although the general "rule" is to defer the payment of taxes whenever possible, deciding whether it's better to take or defer that first required distribution requires some analysis.

Retirement plans may have a later distribution date

There is one situation in which your first required distribution can be taken later than described above. If you work past age 70½ and are still participating in your employer's retirement plan (and you do not own more than 5 percent of the company), you may delay your first distribution from that plan until April 1 following the year of your retirement. Note, however, that a plan is permitted to provide that the RBD for all employees is April 1 of the calendar year following the calendar year in which an employee reaches age 70½.

Tip:     Each year thereafter you have to also take a minimum distribution.

How you calculate this RMD amount is explained in detail in our separate topic discussion on the required minimum distribution rule. What is important here is when you have to start taking these required distributions.

Calculating when minimum distributions must begin

When do you reach age 70½? It's six calendar months after your 70th birthday. Here are a couple of examples of calculating the timing of the first required distribution.

If you were born on June 30, 1945, your 70th birthday is June 30, 2015. You'll reach age 70½ on December 30, 2015. You can either take your first distribution in 2015 (the year you reach age 70½) or delay it until the following April (April 1, 2016).

However, if your birthday was July 1, 1945, you'll reach age 70 on July 1, 2015, and age 70½ on January 1, 2016. You can take your first distribution in 2016 (the year you'll reached age 70½) or delay it until the following April 1 (April 1, 2017).

Note that your second required distribution is required by December 31 of year two (2016 in the first example and 2017 in this last example).

Advantage and disadvantage of speeding up or delaying the first distribution

Maybe taking minimum distributions each year isn't an issue because you're already withdrawing more than the required minimum amount each year.

But what if you don't need the money now in your IRA or plan and you want to keep your funds growing tax deferred for as long as possible? In these cases, you might be thinking that you'd wait until the last possible moment (April 1 of the year after you reach age 70½ rather than in the year you reach age 70½) to take your first minimum required distribution. But that could be a mistake for a couple of reasons.

Caution:         This discussion pertains only to traditional IRAs, not to Roth IRAs. Roth IRAs are not subject to the RMD rule while the Roth IRA owner is alive.

Caution:         Note, however, that the RMD rules do apply to Roth 401(k), 403(b), and 457(b) plans while you are alive.

Why the starting date matters

A distribution from a traditional IRA or retirement plan is generally taxable income in the year made. If all contributions to your IRA were deductible contributions, the entire distribution must be included in your income. If nondeductible contributions were made to the IRA, only part of the distribution is included in your income. Similarly, if after-tax contributions were made to your retirement plan account, part of the distribution is not included in your income.

Example(s):   You reach age 70½ in year one and take your first required distribution in December of year one. Your distribution is included in your income for year one. If, instead, you take your first required distribution in March of year two, your distribution is included in your income for year two.

Your second RMD is due by the end of the year following the year in which you reach age 70½ (the end of year two in the examples given). Unlike your first required distribution, you have no choice about the year in which you receive it. If you don't take your first required distribution by the end of the year that you reach age 70½ (year one), you will actually be taking two distributions in year two. You will have to take your first required distribution by April 1 of year two and your second required distribution by December 31 of year two. So what's the big deal? Well, receiving two required distributions in the same year could push you into a higher tax bracket. Additionally, the extra income might affect the portion of your Social Security benefits that is considered taxable and could have a negative effect on deductions that are sensitive to adjusted gross income.

Example(s):   You are unmarried and reached age 70½ in 2014. You had taxable income of $25,000 in 2014 and expect to have $25,000 in taxable income in 2015. You have money in a traditional IRA and determined that your RMD from the IRA for 2014 was $50,000, and that your RMD for 2015 is $50,000 as well. You took your first RMD in 2014. The $50,000 was included in your income for 2014, which increased your taxable income to $75,000. At a marginal tax rate of 25 percent, federal income tax was approximately $14,606 for 2014 (assuming no other variables). In 2015, you take your second RMD. The $50,000 will be included in your income for 2015, increasing your taxable income to $75,000 and resulting in federal income tax of approximately $14,843. Total federal income tax for 2014 and 2015 will be $29,449.

Now suppose you did not take your first RMD in 2014 but waited until 2015. In 2014, your taxable income was $25,000. At a marginal tax rate of 15 percent, your federal income tax was $3,295 for 2014. In 2015, you take both your first RMD ($50,000) and your second RMD ($50,000). These two $50,000 distributions will increase your taxable income in 2015 to $125,000, taxable at a marginal rate of 28 percent, resulting in federal income tax of approximately $28,071. Total federal income tax for 2014 and 2015 will be $31,336--almost $1,887 more than if you had taken your first RMD in 2014.

Jared Daniel may be reached at www.WealthGuardianGroup.com or our Facebook page.

IMPORTANT DISCLOSURESBroadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual's personal circumstances.To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law.  Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials.  The information in these materials may change at any time and without notice.