Watch out for this ‘double whammy’ on required minimum distributions

If you own one or more traditional IRAs and turned or will turn age 72 this year, you’re now exposed to the dreaded federal income tax IRA required minimum distribution (RMD) rules.

These rules make well-seasoned IRA owners like you take annual taxable withdrawals from your traditional IRAs. The same RMD rules also apply to simplified employee pension (SEP) accounts and SIMPLE-IRAs. (In contrast, Roth IRAs set up in your name are exempt from the RMD rules for as long as you live.)

As you might suspect, the reason behind the RMD rules is to force folks who would otherwise leave their traditional IRA balances untouched to start taking withdrawals and paying the resulting federal income tax hit. If you think the RMD rules are just a minor nuisance that you can safely ignore, think again. If you fail to withdraw at least the RMD amount for the year, the IRS can assess a 50% penalty on the shortfall. That’s one of the most punitive penalties in our beloved Internal Revenue Code. Avoiding the penalty means complying with the RMD rules. So let’s do that.

Here in FAQ format is what you need to know to stay out of RMD trouble, taking into account the possibility that your marginal federal income tax rate could be higher next year if President Biden’s tax proposals succeed.

When must I take my first RMD?

You have two choices for when to take your initial RMD, which is for the calendar year that you reach the magic age of 72.

Choosing Door No. 1 means taking it during the year you turn 72.

Choosing Door No. 2 means taking your initial RMD by no later than April 1 of the year after you turn 72.

Regardless of which door you choose, the initial RMD relates to the calendar year that you turn 72. Then for each subsequent calendar year, you must take another RMD by no later than December 31 of that year. Of course, you’ll also owe the related federal income hit—and maybe a state income tax hit too, depending on where you live. Ugh!

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If you turned or will turn 72 this year, the important thing to understand so far is that choosing Door No. 2 means you must take two RMDs in 2022 to avoid the 50% penalty. The first RMD will be for calendar year 2021 (the year you hit the magic age), and that one must be taken by no later than 4/1/22. The second RMD will be for calendar year 2022, and that one must be taken by no later than 12/31/22. Confusing? You bet. Thank your beloved Congress (not the IRS) for all this.

Does choosing Door No. 2 create a tax risk?

Yep. If you turned or will turn 72 this year, choosing Door No. 2 would create a double RMD whammy in 2022, because you would have to take two mandatory withdrawals next year and pay the resulting double tax hit. That’s no big deal if you only have a modest amount in your IRA(s). So, in that case, putting off the tax bill for your initial RMD until next year could make perfect sense — especially if you expect to be in the same marginal tax bracket next year or a lower one.

But if you have big bucks in your account(s), taking two RMDs next year could shove you into a higher tax bracket and also cause you to lose tax breaks that are phased out as income goes up. That would be bad news in any year, but it could be especially bad news next year if Congress and President Biden collaborate to raise your tax rate for 2022.

Biden wants to raise the top marginal federal income tax rate from the current 37% to 39.6%. He has stated that folks with income under $400,000 won’t be affected by any tax increase. But it’s unclear what the $400,000 figure might mean. Does mean adjusted gross income (total income reduced by certain deductions such as self-employed retirement plan contributions and allowable write-offs for alimony payments)?

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Or does it mean taxable income (total income reduced by all allowable deductions including itemized deductions or the standard deduction, whichever applies)? If the $400,000 figure is for married joint-filing couples, what about singles? Will they be hit with a higher tax rate if they have over $200,000 of income (however it might be defined)? As this was written, we don’t know the answers to any of these questions. Stay tuned, because we may have some specifics soon.

What if I have several IRAs?

If you have several traditional IRAs (including any SEP accounts and SIMPLE-IRAs), your annual RMD amount is based on the combined balances of all those accounts. However, there’s no requirement to actually withdraw RMDs from each separate account. Instead, the required amount can be withdrawn from as few (or as many) IRAs as you wish. For instance, if you have three accounts, you could withdraw the entire RMD amount from just one account.

How do I calculate RMDs?

The RMD for a year depends on the combined amount of your traditional IRA balances as of December 31 of the previous year divided by a life expectancy figure provided by the IRS. The RMD amount must be recalculated annually, because the IRA balance is a moving target, and so is the life expectancy divisor. As you grow older, the life expectancy divisors get smaller, which means the annual RMDs become a bigger and bigger proportion of your combined IRA balances.

Example: You are unmarried and turned 72 this year or will reach that age by yearend. To avoid a double tax hit for 2022, you choose Door No. 1 and take your initial RMD this year rather than next year. Probably a good idea. Here’s the drill.

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Divide your combined IRA balances as of 12/31/20 by 25.6 (the life expectancy divisor for a 72-year-old from the IRS table. Say the combined balances were $500,000. The initial RMD amount is $19,531 ($500,000/25.6). Make sure to withdraw at least that amount by 12/31/21 (you get credit for any amounts withdrawn earlier in the year).

Next year, you must take your second RMD by 12/31/22. The required amount for next year will equal your 12/31/21 combined IRA balances divided by 26.5 (the life expectancy divisor for a 73-year-old, which will be your age as of 12/13/22). And so on for each subsequent year.

Key point: In most cases, your IRA custodian or trustee will calculate RMD amounts for you. But it doesn’t hurt to know the drill. We take nothing for granted!

The bottom line

You have a 2021 tax planning opportunity if you turned or will turn age 72 this year. If you choose to take your initial RMD this year (Door No. 1), you avoid the possibly harmful tax impact of having to take two RMDs next year.

Once again, this is only an important issue if you have significant bucks in your IRA(s). If you do, having to take two RMDs next year (because you chose Door No. 2) could shove you into a higher tax bracket. Maybe higher than you think if tax rates go up next year. You might also lose some tax breaks next year due to income-based phase-out rules. Consider consulting your tax advisor if you’re in this situation, and take action before year-end if Door No. 1 looks like the best option.

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