Michael Callahan
As we move into the final quarter of the calendar year, financial planners are fielding all kinds of tax, retirement and investment questions from clients. Just one of the many that planners might hear is, what types of distributions should I be making before the end of the year? If you own a retirement account or mutual funds, planning for distributions now may help you avoid paying penalties next year.
Required Minimum Distributions
Typically when financial planners talk to clients about taking distributions before the end of the year, required minimum distributions are what we’re talking about. Certain types of distributions are only relevant for people in specific jobs or with particular investments, but required minimum distributions (RMDs) affect millions of older Americans across all tax brackets. RMDs may also be relevant to anyone who owns an inherited retirement account.
Many common retirement account types have RMDs. Without them, an account owner could theoretically let the money in a retirement account grow tax-free indefinitely, until they die and their account is transferred to an heir. To keep that from happening, the IRS requires that account owners withdraw at least some of the money each year (and pay taxes on it) once they reach a certain age. Retirement account owners are currently required to take RMDs every year starting at age 72.
What accounts have required minimum distributions?
Per the IRS, required minimum distribution rules apply to:
- Traditional IRAs
- SEP IRAs
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans
- 457(b) plans
Note that Roth IRAs are an exception to the RMD rules. Roth accounts are exempt from these types of distributions while the owner is alive.
How do I know how much to take for these types of distributions?
The way RMDs are calculated can be a little complicated. To figure out how much you need to take from your account this year, start with the account balance from December 31 of last year. Divide this number by a life expectancy factor to find your required distribution for this year. The IRS publishes multiple life expectancy tables, which is where you’ll find the life expectancy factor you need. There are different tables for account owners in different circumstances, which makes calculating RMDs even more complicated. Speak to your financial planner for help if you need it.
What about distributions from inherited accounts?
If you’re someone who has inherited a loved one’s retirement account, the RMD rules are determined by your relationship to the account owner and the type of account. Generally speaking the new owner can’t let any years lapse between RMDs. So if you inherited an IRA from someone who died during 2022 and hadn’t yet taken their RMD from the account, you must take the 2022 distribution before December 31st. The amount that you must take is calculated based on your own life expectancy factor, not the original account owner’s.
Non-spouse beneficiaries who inherit an IRA may have to distribute the entire amount within five or 10 years of the account owner’s death. The specific requirements vary depending on your circumstances. Talk to your financial planner for specific guidance about your inherited accounts.
How are RMDs taxed?
Most types of RMDs are treated as taxable income, so you’ll pay your individual income tax rate on any amount you distribute. Roth accounts are again the exception. If the owner held the account for at least five years before their death, the beneficiary who inherits the account can take RMDs tax-free.
What happens if I don’t take RMDs?
The penalty for not taking RMDs by December 31st is severe. The IRS imposes a 50 percent penalty on any amount that you fail to take. If you’re supposed to take a $10,000 distribution from an IRA and you forget, you’ll pay a $5,000 penalty. Or, if you only take $8,000 from the account, you’ll pay a $1,000 penalty—50 percent of the $2,000 shortfall.
Capital Gains Distributions
Some taxpayers are also doing some tax planning around capital gains distributions as we near the end of the calendar year. Mutual funds may pay out these distributions to individuals who own part of the fund. They’re paid out once per year, typically in December. Capital gains distributions happen when mutual funds make profits from selling capital assets during the year. Those profits are distributed among the fund owners at the end of the year.
Because the IRS considers capital gains distributions income, a taxpayer who receives them must pay taxes on that money even if they reinvest their distributions back into the fund. The length of time the fund owned assets before selling them determines whether those profits are taxed as short-term or long-term gains. Even if you buy into a mutual fund in autumn, you may pay long-term capital gains taxes on distributions you receive that December.
While it’s the account owner’s job to take RMDs from retirement accounts, mutual funds proactively pay out capital gains distributions. So you generally don’t need to take any action to withdraw these types of distributions before the end of the calendar year. Your responsibility is primarily to pay taxes on the money and report it on your next tax return.
Questions About Distributions and Year-End Tax Planning?
Sachetta, LLC is gearing up for a busy autumn helping our clients strategize about year-end financial planning, and anticipating the tax planning issues that might be coming up next year. If you have questions about these types of distributions, or any financial planning questions we can answer, contact us today.
Michael J Callahan, CPA, CFP®, MST has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years. Our ideas about money are formed by our life experiences. Over the years, Mike has seen those close to him make common money mistakes from not having enough life insurance, to not doing the proper estate planning. When he received an inheritance in college and started looking into how he could use it to achieve his goals, he realized that he could use those experiences to help others. He changed his major to Finance, and the rest is history.