If you are not already, one day you will most likely be lucky enough to reach age 70. At that time, you will also likely be aware of the Required Minimum Distribution rules that will apply to any pre-tax sheltered retirement accounts (such as IRA and 401k accounts) that you have. Under those rules in the federal income tax code, taxable distributions from these accounts must begin in the year that you reach 70.5 years old.
There is one exception to that beginning date. You are permitted to postpone the first withdrawal until no later than April 1st of the following year if you feel it would be to your financial advantage. If you are not sure whether it would be beneficial to defer some or all of the first distribution, by at minimum three months into the next calendar (tax) year, then a consultation with a Certified Public Accountant or other tax professional can be time well spent.
Some things to Know When Deferring Your First Distribution:
--If you defer your first distribution, you will be required to receive two distributions in your second year (the first before April 1st of the following calendar year and the 2nd before December 31st).
--The deferral will push your tax liability for both distributions into that following tax year.
--Determine whether having two distributions will put you in a higher tax-bracket causing any of the deferred distribution to be taxed at a higher marginal income tax rate.
The Optimum Tax Strategy (Part 1):
--If some of your deferred distribution will be taxed a higher marginal income tax rate, it will usually be better not to defer your first Required Minimum Distribution. In this case, you should make sure that enough has been withheld to cover the federal tax that is owed on the distribution.
--If the income tax that is withheld is enough, you will not only avoid IRS penalties for underpayment of taxes due, but also avoid having to make an Estimated Tax payment as an alternative way to pay the required taxes.
Know and Follow the Underpayment Penalty Rules:
--The U.S. income tax system is a “pay-as-you-go” system, which means that you must pay income tax as you earn or receive it during the year. You can do this either through “withholding” or by making “estimated tax payments”. If you do not pay enough tax throughout the year using either or both methods, you may have to pay a penalty.
--Most tax payers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% (110% for higher income taxpayers) of the tax shown on the return for the prior year, whichever is smaller. [There are special rules for farmers and fishermen, certain household employers and estimated taxes need certain higher income taxpayers. For more information, refer to Publication 505, Tax Withholding and Estimated Tax.]
--Generally, taxpayers should make estimated tax payments in four equal amounts to avoid a penalty. However, if you receive income unevenly during the year, you may be able to vary the amounts of the payments to avoid or lower the penalty by using the annualized installment method. [Use Form 2210.pdf, Underpayment of Estimated Tax by Individuals, Estates, and Trusts, to see if you owe a penalty for underpaying your estimated tax.]
The Optimum Tax Strategy (Part 2):
--If you determine that the conditions discussed above will make it advisable to defer your first distribution, it may be beneficial to defer paying the tax that will be due for as long as possible. The key point to remember is that using the withholding method to fully pay income taxes that are owed will enable you to wait on paying taxes up until the last point in the year that you have income that the tax can be withheld from.
--An acceptable example of this strategy is accomplished by withholding enough to pay taxes for both distributions from your 2nd Requirement Minimum Distribution. Just make sure that the total amount of taxes paid for the year is enough to meet the rules describe above to avoid an underpayment penalty.
Why Deferring May Be Beneficial:
--Deferring a distribution will permit the amount of money representing the taxes due to stay invested in your tax-sheltered account for a longer period. This can provide up to one full year of potential additional investment return on the tax that would have been withheld and thereby removed from any further potential investment gain.
--Even though the deferral will cause the calculation of the following year’s distribution and tax to be somewhat larger (because it will be added to the year-end value used to calculate the following year’s minimum distribution), the investment return on the deferred tax may generously exceed the additional tax amount.
--A calculation that is specific to one’s own situation can be made. Generally, one can expect to be better off deferring the first Required Minimum Distribution if one expects to earn a return on the deferred distribution that will be more than the additional tax that will be incurred. As a rule-of-thumb, the return that is necessary over the following year will be any amount that is more than 5%. This can be accomplished in years that are accommodating to investors.
Greg Tinaglia
Last Updated: 10/11/2018