Image with the word required minimum distribution stacked with RMD highlightedThe rules for taking a required minimum distribution (RMD) are complicated. With the IRS, that's not surprising. And the penalties for noncompliance are stiff. If you miss taking an RMD or take out less than what is required, you will pay a 50% penalty. Yes, you read that right, a 50% penalty.

In today's post, I'll walk you through the rules, show you how to calculate your RMD so you get it right and avoid any costly penalties.

In most cases, the custodian where you have your IRA will calculate the RMD for you. But they are not perfect. And mistakes are costly (see above). I want you to understand how to calculate the RMD yourself to be sure you don't pay penalties for someone else's mistake.

We will begin with the basics and talk about some potential traps to avoid along the way. I'll point you to some resources at the IRS, including the life expectancy tables and the “rule book” for IRAs where you'll find everything you need.

Let's start with the reason you have to take a required minimum distribution in the first place.

Why RMDs

In the majority of cases, money contributed (deposited) into an IRA is pretax. In other words, you've never paid taxes on the money. In 2019, taxpayers can contribute $6,000 to an IRA and deduct that payment from their income. Taxpayers over age 50 can make another $1,000 “catch-up” contribution bringing their total to $7,000.

In the simplest of explanations, if you make $50,000 and contribute $7,000 to an IRA, you lower your taxable income to $43,000. That's a pretty good deal. There are income restrictions on the deductibility of contributions. There are also limitations for those who contribute to an employer-sponsored retirement plan (401(k), 403(b), etc.). There are also alternative ways to get money into an IRA.

In most cases, you have never paid tax on contributions to your employer's retirement plans (401(k), 403(b), 457 plans, etc.) and traditional IRAs. Also, you have never paid taxes on the earnings in these accounts. That's one of the significant advantages of these plans. The exceptions are accounts where you paid taxes on contributions before making them.

Any money taken out of these retirement accounts is added to your income and taxed at that year's calculated tax rate. If allowed, many investors would prefer to keep their money in these accounts forever to avoid paying taxes.

However, the IRS is not going to let that happen. They've allowed you to deduct the contributions from your income each year. They've allowed those contributions to grow and compound each year without taxing the earning. At some point, the IRS wants taxes paid on that money. The result – the required minimum distribution.

NOTE: You should also know the difference between a Roth IRA and a traditional IRA. Many people choose a Roth IRA to avoid the hassle of taking a required minimum distribution.

When RMDs must start

The assumption for the following discussion is that your entire IRA is filled with pretax money and earnings on which you have never paid taxes.

The rule says RMDs must start the year following the year you turn 70 1/2.

In general, you need to make these distributions by December 31 of the year they are due. The exception to that rule is the first distribution. The IRS allows you to delay that first distribution until April 1 of the year following the year you turn age 70 1/2. For example, if you were born between July 1, 1948, and June 30, 1949, you turn 70 1/2 in 2019, you must take your first distribution by April 1, 2020, from your IRA accounts.

There is a caveat to this rule. If you delay the first year distribution to the following year, the IRS requires you to take two distributions in that year. Why?

The rule says you can only delay taking your first distribution before the end of the year. After that, all RMDs are due by December 31 of the year they are due. Since you have an RMD due for 2020, that distribution is due by 12/31/2020. The result – both your 2019 and 2020 distributions come out in 2020. Is that a bad thing? It depends. Taking both in one year means you have a higher tax bill due. You may not want that.

Determining the RMD

Three things determine your RMD.

  1. Age
  2. Life expectancy
  3. IRA account balance

Use your age on December 31. In our example, those born in 1948, are age 71 on December 31. Those born in 1949, use age 70. You get the life expectancy from the IRS Uniform Life Expectancy table. Your IRA account balance is as of December 31 of the year before you turn 70 1/2. In our example, that the balance on 12/31/2018.

The IRS publishes a  Required Minimum Distribution Worksheet to help investors calculate RMDs. The uniform life expectancy table is in the worksheet. Here's how it works.

If you are age  71 on 12/31/2019, the IRS says your distribution period (factor) is 26.5 years. Assuming an account balance of $100,000 on 12/31/2018 your RMD is $3,773.58 ($100,000 divided by 26.5). If you are married and your spouse is ten years younger than you, use the IRS Joint Life Expectancy table to get your factor.

You can find the life expectancy tables and distribution rules in IRS Publication 590-b.

Taking your RMD

Once you know your RMD amount, the next decision is how and when to make it. If it's your first, decide whether to withdraw it the year you reach  70 1/2 or by April 1 of next year. You pay taxes based on the year money is distributed. So, by delaying, you would take two distributions in one year and pay taxes on both in a single year. If you have more than one IRA, calculate each one separately.

Once calculated, you have two choices on how to take them:

  1. Take each calculated RMD from each account separately
  2. Aggregate all RMDs and take the total from one account.

This option is only available for IRAs. If you are no longer working and have more than one employer retirement plan, you must calculate and take RMDs from each account separately.

The penalty for missing your RMD or not taking enough is 50% of the amount you should have taken less the amount withdrawn. For example, if your RMD was $20,000 and you only took out $10,000, you would be required to take out the $10,000 (and pay taxes on it) plus pay a penalty of $5,000 (50% of $10,000). You don't want that to happen.

Backdoor Roth IRAs

The backdoor Roth IRA is simple on the surface. The first step is to make a non-deductible contribution to an IRA. The income limits for contributions do not apply for non-deductible IRAs. You have paid taxes on the money already. If you stay within the contribution limits, you're good to go. For easier accounting, I recommend keeping your non-deductible IRA separate from IRAs in which you made pre-tax contributions.

Once the IRA is in place, the second step is to convert the traditional IRA to a Roth IRA. Here is where the potential pitfalls come into place. You might think that since you've already paid taxes on the non-deductible IRA contributions, you won't pay taxes when you convert.

You would be wrong.

Pro-rata rule

If you have traditional IRAs funded with pre-tax dollars, Roth IRAs funded by converting traditional IRAs, and other non-deductible IRAs, any withdrawals will be subject to the pro-rata rule. That means you will pay taxes on the converted money.

Here is an example:

Katy has an IRA worth $95.000. The entire IRA consists of pre-tax contributions and earnings. She wants to contribute to a Roth IRA but makes over $200,000, putting her over the income limit. Katy is also covered under an employer retirement plan. She is over the income limit for a deductible IRA contribution as well.

Katy decides she wants to make a non-deductible contribution to an IRA. She decides to contribute $6,000 in 2019. She knows about the backdoor Roth and decides to convert the $6,000 to a Roth IRA. Within a week, she completes the conversion to the Roth, minimizing or eliminating taxes on any earnings (she left it in cash). She thinks because the money converted was after tax, she won't owe taxes on the converted money.

Calculating the pro-rata amount

With the pro-rata rule, the IRS considers all IRAs as one IRA. That includes balances in traditional IRAs, SEP IRAS and Simple IRAs.

Roth IRA and inherited IRA balances do not count in the calculation. Non-IRA employer plan balances get excluded as well. Here's how to calculate the pro-rata rule:

Total after-tax amounts in all applicable IRAs (those listed above) / Total balance of all applicable IRAs = % of distribution that is tax-free.

Because Katy has $95,000 in a traditional IRA consisting of pre-tax money, she will be subject to the pro-rata rule. Instead of the $5,000 conversion being tax-free, only 5.00% or $250.00 is tax-free. The remaining $$4,750 gets taxed at her ordinary income tax rate.

Here is the calculation – $5,000/100,000=5.00% or $250.00(5.00% X $5,000). Katy is married. Their combined income falls into the 24% tax-bracket, making the tax due on the conversion $1,140.00 ($4,750 x 24%). I'm sure Katy would not be happy getting the extra tax bill.

Final Thoughts

As you see, there is a lot to consider when taking a required minimum distribution. If you have one IRA, no company retirement plan, and no Roth IRA accounts, it's pretty simple. However, that is rarely the case. Almost everyone has an employer-sponsored retirement plan. Almost everyone has more than one IRA. In the past ten to fifteen years, more and more people have Roth IRAs added to their retirement accounts.

Tax-free income from Roth IRAs is a huge benefit to many people. That's why many choose to convert their traditional IRAs to Roth IRAs over time. That also creates the problem of dealing with the pro-rata distribution rules.

Planning well in advance of turning age 70 1/2 will help reduce the impact of taxes on your RMDs. It will also help avoid penalties and, potentially reduce taxes on your Social Security benefit.

Everyone who files a tax return knows the rules seem more and more complicated each year. Rules for taking your required minimum distribution are no different. Utilize the IRS worksheet and tables to calculate your own RMD amount. Match that with what the custodian of your account says it should be.

Knowing and following the rules will help you keep more of the hard earned money you put away for your retirement.