Required Minimum Distribution (RMD)
At age 70-1/2 you are required to begin withdrawing a certain percentage of your pre-tax IRA or 401k accounts each year in order to pay income tax on the amounts withdrawn. This is known as the annual Required Minimum Distribution ("RMD"). The rules governing RMDs can be found on the IRS's web site: Retirement Plans FAQs regarding Required Minimum Distributions. In this article, I review how RMD rules apply to immediate annuity contracts.
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Immediate Annuities and Required Minimum Distributions
Q. Dear Hersh, I am 70 years old. I recently transferred $100,000 from my $300,000 traditional IRA to buy an immediate annuity. Yesterday, I received my first payment from the insurance company. I have a question about how to calculate my RMD since I'll be 70-1/2 soon. Do I combine the $100,000 I transferred to the annuity with my $200,000 IRA or is the annuity separate from my RMD? Thank you. Joe W.
A. Dear Joe, The first thing you need to know is that the RMD rules I'll be reviewing with you are different for different types of annuities. There is one set of rules for pre-tax IRA or 401k monies which you use to buy an immediate annuity, and another set of rules for pre-tax monies which you may use to invest in other types of annuities. I'll explain.
An immediate annuity is created when a lump sum premium is irrevocably converted into a periodic income stream say, for your lifetime. The operative words here are “irrevocably converted." In this case the premium is said to be "annuitized." When an IRA or 401k is annuitized you no longer include the premium or "value" of that annuity in future RMD calculations. The IRS considers such an IRA immediate annuity to have satisfied future RMDs (that is, only with respect to the amount of premium which was used to buy that IRA Annuity). I'll have more to say about this later.
This treatment for RMDs is unique to immediate annuities. If you owned or bought a type of annuity which did have a cash balance account or cash value, for example, a variable deferred annuity or a fixed index annuity, then the cash amounts in that annuity would be subject to RMDs. This is true for as long as the cash value has not been irrevocably converted into an income stream under the contract’s annuitization clause.
Why are immediate annuities "exempt" from RMDs?
There are two reasons for this:
First, an annuitized IRA does not have a cash value to enter in an RMD calculation. When you buy an immediate annuity you relinquish control of the premium to the insurance company in return for an unsecured promise that the company will make certain future payments to you. You no longer own an account with an underlying cash balance. In general, you cannot even withdraw a lump sum payment from your immediate annuity. (Recently, some companies have begun to offer cash advances in their immediate annuity contracts but that has not effected the principle mentioned here.)
A second reason why the IRS has determined that an annuitized IRA should be excluded from RMD calculations is because of the level-nature of immediate annuity payments. An immediate annuity income stream is usually a non-increasing payment stream. The same monthly amount paid to you at age 70 is paid to you when you reach 80 and beyond. The payments, once established, do not change as you get older. RMD distributions, on the other hand, are required to increase as a proportion of the total value of your IRA holdings as you age. So there is a unique challenge in fitting level immediate annuity payments into an increasing RMD model.
A hypothetical RMD calculation for an immediate annuity
Let's look at an example to see why RMDs would not work for an immediate annuity.
If you transferred $100,000 to the IRA annuity at age 70 you may receive $7,000 a year, or 7% of the premium in annual income (you can get an instant calculation of the annual income on our home page). But at age 70 the RMD table calls for only a 3.5% annual distribution, which is just $3,500.
How To Calculate Your Required Minimum Distribution
Find your IRA balance from December 31st of the previous year. Divide this amount by the distribution period found on the chart below using the age you will turn on your birthday this year. This is your RMD amount for this year.
Example: If your IRA balance was $100,000 and your age is or will be 75 this year, you would divide the balance by 22.9. Your RMD for this year would be $4,366.82. You can find the IRS worksheet here.
So at age 70 the immediate annuity could be said to "over distribute" a larger share of your $100,000 than is required if you left the $100,000 in an IRA money market account. Now the annuity will continue to pay you $7,000 a year, equivalent to 7% of your initial premium, for the rest of your life. Yet, the RMD table does not require a 7% withdrawal from IRA holdings until you reached age 85.
Of course,if you live beyond age 85 those same 7% ($7,000) level annual payments generated by the annuity would no longer keep pace with the annually increasing percentage of IRA assets that the RMD tables required.
So, due to these complexities, the IRS has decided that if you annuitize your IRA monies you are considered to have satisfied RMDs with respect to those funds.
(The IRS regs that stipulate premium dollars which were used to purchase an immediate annuity are not included in any future RMD calculations are difficult to wade through but the reference is here. These regs apply to distributions of an IRA or 401k paid in the form of periodic annuity payments for the owner’s or beneficiary’s life (or the joint lives of the owner and beneficiary) or over a comparable period certain and where the payments are nonincreasing. This is the definition of a fixed immediate annuity contract.)
What about RMDs in the year in which I buy my annuity?
In the year in which you buy your immediate annuity you do have a unique obligation to calculate RMDs. While you won't have to calculate RMDs with respect to the premium that you spent on your annuity in all other years, in the year in which you buy your annuity, however, you must be sure there's no shortfall in the RMD.
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Here's how to go about it: add up all the monthly payments you received (or, are expected to receive) from the annuity in the first year and subtract that amount from your total required minimum distribution obligation for that premium amount in that year. You must make up any required minimum distribution shortfall from other lump sum (non-annuitized) IRA or 401k accounts you own.
Sometimes, it's easier to take care of the first year's RMD by simply removing the full RMD amount from the IRA lump sum before you convert it into an immediate annuity. That way you know you've satisfied RMDs with respect to that money for the complete first year.
Are there penalties for not taking RMDs?
The IRS requires you to begin withdrawing around 3.5% from your IRAs upon reaching age of 70-½. Failure to do so can result in steep penalties, as high as 50%. The Treasury Inspector General recently reported that as many as 250,000 tax payers fail each year to withdraw the required amount from their IRAs.
Why are so many retirees failing to meet the IRS’s required minimum distribution (RMD) withdrawals?
In most cases, retirees fail to withdraw the required funds from their IRA’s annually by accident. In some cases, multiple accounts spread across multiple financial institutions could play a part in this growing trend. Or, these tax payers may have simply incorrectly calculated the amount to withdraw for the given year. In any event, it's important you don't forget to withdraw the correct amount.This FAQ reviews some of the important aspects of RMDs you may not have heard about.
How much is the penalty for failing to take RMDs?
Currently, the IRS can assess a penalty as high as 50% of the amount that should have been taken out. For example, if you were required to withdrawal $10,000 from your IRAs and you failed to do so, your IRS penalty could be as high as $5,000! In addition, you will be responsible for federal income taxes on the $10,000 amount once you do take the RMD.
I failed to take out RMDs in prior tax years. Is there a penalty?
Yes. There is no statute of limitations on how far back the IRS can look for RMD mistakes. If you have discovered mistakes in prior year’s withdrawal amounts, correct those figures immediately.
If you can provide evidence that you made a reasonable mistake when calculating distributions for prior years, the IRS does have the ability to waive penalty fees. The most common reasons considered for waiving fees include serious illness or dementia.
How can I avoid IRS penalties in the future?
The most important thing to do is accurately track all of your IRA accounts at various firms. Your total annual distributions from these IRA accounts must be coordinated. Of course any IRA monies you've converted into an immediate annuity would not be subject to or trigger RMD penalties.
More RMD FAQs
Q: How are RMD’s taxed? A: RMD’s are taxed as ordinary income.
Q: Is it possible to take withdrawals from my IRA accounts prior to the age of 70 ½? A: Yes, you can take withdrawals from your IRA accounts at any point. However, distributions taken prior to you reaching the age of 59 ½ are subject to an IRS early withdrawal penalty of 10%.
Q: I have several 401k plans still with former employers. Do I need to consider the balances in those accounts when calculating my annual RMD’s? A: Yes. Distributions made from qualified plans and/or IRAs count toward your annual RMD requirement.
Q: How do I calculate the amount I owe in RMD’s each year? A: Your annual required minimum distribution amount is based on your age and your total investable qualified assets. Locate the divisor number (in the RMD table on this page) for your age. Divide the total amount you have invested in qualified plans and IRA accounts (except immediate annuities) by this divisor number. This will be your RMD withdrawal amount for this tax year.
Q: I am married. Will my spouse’s age impact my RMD amount? A: Your spouse’s age can impact your required minimum distribution amount; for example, if he or she is listed as your IRA account’s sole beneficiary or is more than 10 years younger than you.
Q: I have multiple IRA and 401k accounts, each with a different cost basis. Does my cost basis impact the amount owed in RMD’s? A: Generally the term "cost basis" should not apply to IRA or 401k accounts. Cost basis, also called tax basis, refers to the amount of after-tax money you invested and is used to calculate if you have a taxable gain when you sell the investment.
Typically, contributions to an IRA or 401k are made with pre-tax money. So there is no cost basis. However, if you made nondeductible contributions with money on which you already paid taxes you shouldn't be taxed again when you withdraw them. Best, to consult a CPA for detailed instructions on how to handle RMDs when there is a cost basis.