You'll pay a 50% penalty tax if you err with required minimum distributions.
By Sue Stevens, CFA, CFP, CPA | 10-12-06 | 06:00 AM | Email Article

A sure rite of passage into retirement occurs when you must begin taking money out of your retirement plans. If you have a traditional IRA or company retirement plan, the "magic age" is 70�. If you have a Roth IRA and you didn't inherit it, you're off the hook--there are no required minimum distributions (RMDs).

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

If you've inherited an IRA, you'll have to take required minimum distributions, too (even for Roth IRAs). These rules are tricky, so make sure you leave enough time to figure out what you're supposed to do before year end.

Of course, you can always take more than the minimum, but don't try to take less. If you don't handle your RMDs properly, you'll get stuck with a 50% penalty for what you should have taken but didn't, as well as ordinary income tax on your distribution. So be careful!

Lifetime Distributions
When you're ready to calculate your RMD, you'll use one of three tables:

  • Uniform Lifetime Table: Most people will use this table. The exceptions are: 1) spouses who are sole beneficiaries and who are more than 10 years younger than the IRA owner, and 2) beneficiaries.
  • Joint Life Table (on Page 86): You will use this table if you have a spouse who is the sole beneficiary and who is more than 10 years younger than you are.
  • Single Life Table (on Page 2): For beneficiaries.

Let's start with the most common situation. You're about to turn age 70� and you need to start taking distributions. Everybody--except those folks with spouses more than 10 years younger--will use the Uniform Lifetime Table. You look up your age and find your factor. Then you take the balance of your retirement accounts as of Dec. 31 of the prior year and divide by your factor.

For example, according to the Uniform Lifetime Table, the factor for age 70 is 27.4. So, for your first RMD, you would take your retirement plan balance as of Dec. 31, 2005, and divide by 27.4 to get your minimum required distribution.

You must start taking distributions by April 1 of the calendar year following the year when you turn age 70�. For example, if you turned 70 on May 1, 2006, you'll be 70� on Nov. 1, 2006. So you'd be required to take your first distribution by April 1, 2007. You'd have to take your second distribution by Dec. 31, 2007. So in this situation you'd be taking two distributions in one year.

If you are married to someone more than 10 years younger than you are, and your spouse is your sole beneficiary, you should use the Joint Life Table (after clicking, scroll down to Page 83). For example, if you are age 72 and your spouse is 56, your joint life expectancy factor would be 30.0, so you'd divide the prior year's retirement balance by 30.

Whether you use the Uniform Lifetime Table or the Joint Life Table, you go back to the table each year to look up a new factor.

When you take your required minimum distribution, you are taxed at ordinary income rates for tax purposes. If you fail to take your minimum distribution, you are penalized at 50% of what you should have taken but didn't. That's on top of paying ordinary income tax on the distribution.

There are a couple of exceptions to the general rule for lifetime distributions:

  1. If you are still working and participating in a company retirement plan, you can delay taking required minimum distributions from the company plan until you actually retire. This does not generally apply to self-employed individuals. If you have an IRA in addition to your company retirement plan, you must start taking distributions from the IRA at 70� even if you are allowed to delay distributions from your company retirement plan.
  2. If you participated in a 403(b) plan before 1987, you may be able to delay distributions on that part of your plan until age 75.

Inherited Retirement Plans
So far, so good. Now we get to the hard stuff--which set of rules to follow if you inherit a retirement plan. There are different rules that are dependent on whether the owner died before or after beginning minimum distributions. There are also different rules for spouses and non-spouses.

Final Beneficiary
Before we get into the nitty gritty of handling distributions from inherited retirement plans, let's deal with the concept of "final beneficiary." You may be wondering, isn't the final beneficiary the person you name in your will or estate plan? Yes, but it's not that simple. Just as you'd expect, you must name your beneficiaries while you are alive; no one can add or change your beneficiaries after you're gone.

But unlike under the older rules, you can change your mind about your beneficiaries right up until the day you die. Moreover, it's possible for your beneficiary to change after you've died. Say, for example, you name your spouse as primary beneficiary and your daughter as secondary beneficiary. If your wife chooses to, she could disclaim her interest in the retirement plan, and it would pass to the secondary beneficiary. Your daughter would be the final beneficiary.

The new rules specify that the final beneficiary is determined by Sept. 30 of the year following the owner's death. In our example above, your daughter would be the final beneficary if your wife disclaimed her interest in the retirement plan by September 30 of the year following your death.

Next, let's outline different scenarios based on whether the owner had begun taking minimum distributions or not and who is the beneficiary.

Owner Dies Before Starting Required Minimum Distributions

  1. Spouse Is Sole Beneficiary
    When the spouse is the beneficiary, he or she will have several choices concerning what to do with the assets:
    1. He or she can roll over the deceased spouse's retirement plan into his or her own traditional IRA (or a Roth IRA can be rolled over into a spousal Roth IRA). Then required distributions wouldn't be necessary until the surviving spouse turns age 70�. (In the case of a Roth, no distributions would ever need to be made until both spouses were deceased.) The surviving spouse can name whomever he or she would like as beneficiaries of his or her own IRA. Since the surviving spouse now owns the IRA, he or she would follow the Uniform Lifetime Table for determining life expectancy factors.
    2. He or she can leave the assets in the deceased's IRA and take minimum distributions by the later of:
      1. The end of the calendar year following the year in which the spouse died OR
      2. The end of the calendar year in which the spouse would have turned age 70�

    If you are using "B" from above, the spouse would use the Single Life Table (on Page 2) to determine the factor to use based on his or her own age at the time of distribution. Then he or she would go back to the Single Life Table each succeeding year and find a new life expectancy factor to use. These rules for succeeding years are different than the rules for non-spouse beneficiaries.

    A spouse should choose NOT to roll over an IRA into his or her own IRA if he or she is younger than age of 59�, and therefore subject to an early-withdrawal penalty of 10%. In this case, the spouse would be better off not rolling over the IRA and waiting until the deceased spouse would have been age 70�. At that time he or she could take distributions from the owner's IRA and not incur penalties.

  2. Non-Spouse Is Beneficiary
    First you have to determine if a person (or certain trusts) is the beneficiary, or if an institution such as an estate or a charity is the beneficiary.
    1. If an individual is named as beneficiary, he or she would need to start taking minimum required distributions by the end of the calendar year following the calendar year of the owner's death. He or she would use the Single Life Table (on Page 2) to find the factor based on his or her own age in the year of the first distribution.

      In succeeding years, the life-expectancy factor is calculated by taking the prior year's factor and subtracting one. So, if the first year's factor is 40.7, the second year's factor would be 39.7. This is different from the rules in succeeding years for a spousal beneficiary.

      If the beneficiary is younger than age 59�, there is no 10% early distribution penalty for taking required minimum distributions from an inherited retirement plan.

    2. If an estate or charity is named as beneficiary, the "five year rule" applies. All assets must be withdrawn from the retirement plan by the end of the fifth year following the year of the owner's death. Partial withdrawals may be made anytime before the end of the fifth year, but everything must be out of the plan by the end of the fifth year. Any failure to withdraw the assets results in a 50% penalty (on top of the income tax) of what should have been withdrawn and wasn't.

Owner Dies After Starting Required Minimum Distributions

  1. Spouse Is Sole Beneficiary
    Similar to when a spouse dies before starting to take distributions, the surviving spouse may roll over the retirement plan into his or her own IRA. The one difference is that if the beneficiary has not yet taken the required distribution for the year in which the owner died, that amount must be paid out before the surviving spouse rolls over the IRA into his or her own IRA.

    If the surviving spouse chooses to roll over the retirement plan into his or her own IRA, then he or she will follow the Uniform Lifetime Table for determining life expectancy factors. This table has longer life expectancies than you will find in the Single Life Table for beneficiaries.

  2. Non-Spouse Is Beneficiary
    Once again you'll need to determine if an individual has been named beneficiary or not. If the estate (or a charity) is the beneficiary, for required minimum distribution purposes, there is no "designated" beneficiary.

For example, say the owner's IRA named the estate as beneficiary, and the owner's son is the beneficiary of the estate. Because the estate was named beneficiary of the IRA instead of the son, the assets in the IRA must be withdrawn based on the deceased owner's life-expectancy factor instead of the son's life-expectancy factor. Further, if the required distribution for the year of the owner's death has not yet been made, it must be paid out as soon as possible. The first required distribution for the son must occur by the end of the calendar year following the calendar year of death. The Single Life Table (on Page 2) would be used to look up the owner's age in the year of death. Let's say the factor is 8.6 (death at age 83). The son would subtract one from this factor (to get 7.6) and use that to divide the prior year-end retirement plan balance to get his required minimum distribution.

I told you this wasn't simple!

Now let's look at the same example, only this time an individual--the son--is named beneficiary of the IRA. In this case, the son can base his required minimum distributions on his own life expectancy factor using the Single Life Table. If the son was age 65 when his parent died, his factor would be 21. This larger factor will result in smaller required minimum distributions. To calculate his factor in succeeding years, the prior year's factor is reduced by one.

A version of this article appeared September 15, 2005.

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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