Tax Strategies for Individuals
Retirement Plan Distributions: When To Take Them
Table of Contents
The basic rule is that you must begin withdrawing funds – and incurring taxes on these withdrawals – no later than April 1 of the year after you turn 73. This rule exists so that retirement funds will be distributed whether or not spent during what for most people is their retirement years.
Under the SECURE 2.0 Act of 2022, for individuals who reach age 72 after December 31, 2022, and age 73 before January 1, 2033, the applicable age for starting RMDS is 73. For individuals who attain age 74 after December 31, 2032, the applicable age is 75. The new rules apply to distributions required to be made after December 31, 2022, for individuals who attain age 72 after such date. In other words, taxpayers born between 1951 and 1959 will begin RMDs at age 73. Those born in 1960 or later will begin taking RMDs at age 75.
An exception to this general rule is that, where your retirement plan permits, you do not need to begin these mandatory withdrawals until you retire if you are still employed when you reach the mandatory withdrawal age. The exception doesn’t apply where you’re a five percent or more owner of the business that provides the plan, or to withdrawals from traditional IRAs – in those cases, you are subject to the mandatory withdrawal rules.
Related Guide: Roth IRAs are another exception. For a discussion of Roth IRAs, please see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.
Preserving the tax shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution or the smaller the amount you must withdraw the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows, to maximize assets and the shelter, for the next generation.
The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter that started out to aid your retirement.The rules are complex, but here’s a general overview of the timing of retirement plan distributions which will help avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules, professional guidance in this area is strongly suggested.
Related Guide: The tax treatment will be dictated not only by the timing of the withdrawal (i.e., when to take it) but also by the form of the withdrawal (i.e., how to take it). This Financial Guide discusses the “when.” For a discussion of the “how,” please see the Financial Guide: RETIREMENT PLAN DISTRIBUTIONS: HOW to Take Them.
Withdrawal While You're Alive
Before You Reach Age 73
Until the year you reach 73, you need not take your money out of your retirement account, although your employer’s plan might require you to do so. In fact, there will usually be a 10 percent early-withdrawal penalty if you make withdrawals from an IRA before age 59 1/2. Between the ages of 59 1/2 and 73; you pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax contributions you made.
Taxpayers affected by the coronavirus were able to withdraw up to $100,000 and will not be subject to the 10 percent penalty for early withdrawals. Distributions must have been taken before December 31, 2020. The amount withdrawn is considered income, however, and taxpayers have three years to pay the tax on the additional income and replace the funds in-kind.
Once You Reach Age 73
Once you hit 73, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 73, but waiting until April 1 of the following year means you must withdraw for two years. To avoid this income bunching and a possible higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 73.
IRS has greatly simplified and relaxed the withdrawal rules over the years to increase the retirement plan tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.
The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your life expectancy. Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the year.
Example 1: Joe reaches age 73 in October of this year. Retirement plan assets in his IRA totaled $600,000 at the end of last year. The IRS number for age 73 is 26.5. Joe must withdraw $22,641 ($600,000/26.5) this year.
The distribution period in the IRS table in effect assumes distribution over a period based on your life expectancy plus that of a beneficiary 10 years younger than you. Distribution after your death is based on the actual life span or life expectancy of your actual beneficiary (see “Withdrawal after You Die” below). Only where your designated beneficiary is a spouse more than 10 years younger than you is his or her actual life expectancy used to figure the withdrawal period during your lifetime. You may use these rules to prolong distribution for 2003 and after, even though you have been taking withdrawals over a shorter period under previous rules.
Under the current rules, the life expectancy of your designated beneficiary (if you have one) is irrelevant in figuring your withdrawal period (except for a beneficiary spouse more than 10 years younger). Thus, you can change your designated beneficiary at will, or replace one who died, without affecting your withdrawal period (except for a change to or from a spouse more than 10 years younger).
You can always take out money faster than required and pay tax on these withdrawals; however, the tax code is strict about minimum withdrawals. If you or your beneficiaries or heirs fail to take out what’s required, a tax penalty will take 50 percent of what should have been withdrawn but wasn’t.
Withdrawal after You Die
The rules as to how fast your beneficiaries or heirs must withdraw funds from your account and pay the income tax-differ, depending on your beneficiary choice.
Under the SECURE Act of 2019, and starting in 2020, there is a new beneficiary category – the eligible designated beneficiary (EDB). An EDB can include the IRA owner’s surviving spouse or minor child, a person who is chronically ill or disabled, or another individual (e.g., parent, sibling, and unmarried partner) who is not more than 10 years younger than the IRA owner at the time of his/her death. If an individual inherits an IRA in 2020 (or in years beyond) but does not meet the definition of an EDB they may be required to take full distribution of the inherited IRA within 10 years after the IRA owner’s year of death.
Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets. You may change the beneficiary later without affecting the amount you withdraw (except for a change to or from a spouse more than 10 years younger).
Eligible Designated Beneficiaries: Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has options that no other beneficiary has such as:
Leave the money in the IRA account. If your spouse, for example, is the sole beneficiary, he or she may elect to treat the balance in the IRA as if it were their own. Depending on their age, they may be required to take required minimum distributions.
Rollover to another IRA. A spouse beneficiary of your IRA can elect to roll the IRA balance over to their own IRA. This provides the optimal extension of the withdrawal period if your spouse is younger than you since your spouse doesn’t have to start withdrawing funds until they turn 73. At age 73, your spouse can then use the period in the IRS table or a longer one if they then has a spouse more than 10 years younger. A rollover isn’t allowed if a trust is a beneficiary, even if the spouse is the trust’s sole beneficiary. A similar extension is allowed for a balance you might leave in a qualified retirement plan: your spouse can roll it over into his or her IRA. And your spouse can roll over a distribution from your retirement plan to another retirement plan in which he or she participates, as well as to an IRA.
Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the money in the deceased participant’s account. There’s no 10 percent early-withdrawal penalty if the spouse takes funds out of your account, but that penalty would apply if the spouse rolled over the money into his or her own IRA and tapped it before reaching 59 1/2.
Leaving the money in your account makes sense if your spouse is under age 59 1/ 2 and needs the money soon after your death. If your spouse remains a beneficiary, he or she doesn’t have to start withdrawals until you would have reached age 73 after which withdrawals will be taken under the IRS table. Generally, there will not be an estate tax on retirement plan assets left to a spouse and the spouse will pay income taxes only as funds are withdrawn.
Eligible Designated Beneficiaries: Your Minor Child. If you name your child you should be aware that upon reaching the age of majority (18 in most states, 19 in Alabama and Nebraska, and 21 in Mississippi) your child will become a non-eligible designated beneficiary and subject to the 10-year rule – i.e., required to take full distribution of the inherited IRA within 10 years.
Non-Designated Beneficiaries. This type of beneficiary does not have a life expectancy. As such, distributions are different depending on whether the IRA account owner dies before, during, or after the start of the required beginning date for required minimum distributions (RMDs). If a traditional IRA owner passes away after his/her RBD, the beneficiary must continue distributions using the decedent’s life expectancy. If before, then the entire account balance must be taken by the end of 5th year following year of death. Beneficiaries of Roth IRA account owners who have died must distribute the assets within five years.
The required payout schedules set the minimum that can be withdrawn. The beneficiary can always take out more.
No beneficiary. If you die before April 1 after the year you reach age 73 having named no beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity), all funds must be distributed and income taxes paid within five to six years of your death. Heirs don’t get the option of using their own life expectancy.
If you die on or after that April 1 date without having named a beneficiary or having named your estate as the beneficiary, the money must come out by the end of the period remaining under the IRS table. For example, at age 80 the table period is 20.2. On a death at age 80, the estate or heirs would have 20.2 years to complete withdrawal.
Death before distributions begin. If you should die before the time (age 73) required distributions are to begin, minimum distributions to your beneficiary can be spread over his or her life expectancy.
Estate tax. There may be an estate tax on retirement funds left to someone other than your spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.
Tax Planning
How Your Heirs Are Taxed
The general rule is that, while there may be a estate tax bite at your death, inherited assets are received income-tax-free by your heirs. Unfortunately, however, this general rule doesn’t apply to money in a retirement plan. Whoever gets the money will incur income tax on it, unless it’s left to charity (more on giving retirement assets to charity below).
If you gave your wife a $500,000 stock-and-bond portfolio, she will not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will be subject to income tax on it, more or less as you would be if you had received the distributions yourself. (Moreover, there may be a further estate tax as well.)
The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates, except for after-tax investments, which come out tax-free. There are, however, the following key exceptions or qualifications:
- On a lump sum distribution, heirs of persons born before 1936 can sometimes claim tax relief.
- Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments, the interest element is taxable.
- The value of a stock bonus is taxable when received as ordinary income, less unrealized appreciation, and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
- Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir can roll over from your account.
- There’s no early withdrawal penalty on what your heir withdraws after your death, even if the heir is under age 59½, but in general, if your spouse is your heir and rolls over your retirement account to his or her IRA, a withdrawal from the IRA while under age 59 1/2 is subject to the penalty.
Some Tax Planning Opportunities
The federal estate tax isn’t a major problem for most Americans. Less than one percent of those who die in any year leave an estate that’s hit by the estate tax; but the larger a taxpayer’s retirement account, the more likely it will be cut down by the federal estate tax on top of the federal income tax described above.
Unlike the income tax, which is collected only as amounts are distributed – and thus is deferred on annuities and the like – the estate tax is collected up front, at the owner’s death, on the present value of the annuity.
One common planning technique – making lifetime gifts to reduce your taxable estate is impractical for retirement accounts. Even where you might be able to give part of your retirement account away (as with an IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter survives for your donee. But there are more practical techniques:
Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the longest period possible.
If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and income taxes on this amount while achieving charitable goals.
A charitable remainder trust is a sophisticated way to benefit family, as well as charity at a reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from the retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is allowed for the present value of what will go to the charity.
Consider buying life insurance to pay estate tax that can’t be avoided (perhaps because you want a large retirement account to go to someone other than a spouse or charity). The insurance proceeds will be exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to income tax). With proper planning, the withdrawn funds can escape estate tax as well.