Roth IRA Required Minimum Distribution (RMD)
At some point, all IRAs must have their balances distributed. The rules which govern those distributions are known as Required Minimum Distributions. The Required Minimum Distributions rules are incredibly complex. This article deals with how these rules operate and how they apply to Traditional IRAs and Roth IRAs. Why are the Minimum Distributions prefaced by the word Required? Simply put, there is a 50% penalty for the amount of Required Minimum Distributions that are not distributed as required.
Are Roth IRAs Subject to the Required Minimum Distributions Rules?
You may sometimes hear or see the statement that Roth IRAs are not subject to Required Minimum Distributions. That is not really accurate. Roth IRAs are not subject to Required Minimum Distributions during the owner's lifetime, but are subject to Required Minimum Distributions after the death of the owner (Read more about using Roth IRAs for estate planning). However, Traditional IRAs are generally subject to Required Minimum Distributions beginning at age 70½. One of the great advantages of Roth IRAs is that they are not subject to these lifetime Required Minimum Distributions rules. This advantage may be the single most valuable attribute of a Roth IRA.
If Roth IRAs are not subject to Required Minimum Distributions rules during the lifetime of the owner, do you need to be concerned about them? The answer is that if you have a Traditional IRA or if you are considering converting a Traditional IRA to a Roth IRA, you will still need to be concerned about the Required Minimum Distributions rules. You cannot do a valid comparison between a Traditional IRA and a Roth IRA without taking into account the Required Minimum Distributions rules. After all, the major advantage of a Traditional IRA is the tax-deferred aspect of such an account. If you are forced to distribute assets out of such an account, you lose that tax-deferral on the amount distributed. So, to the extent that the Required Minimum Distributions rules require you to take money out of the IRA that you did not want or need to take out, you are being hurt financially by those rules.
To What Types of Pensions Do the Lifetime Required Minimum Distributions Rules Apply?
- Corporate and self-employed pension, profit sharing and stock bonus plans qualified under IRC Sec. 401(a) (includes Keogh or H.R. 10 plans, 401(k) plans, and employee stock ownership plans or ESOPs)
- Individual Retirement Accounts (IRAs) under IRC Sec. 408(a)
- Simplified Employee Plans (SEPs) under IRC Sec. 408(k)
- Tax-sheltered annuities (except for account balances existing on 12/31/86 if kept separate for accounting purposes) under IRC Sec. 403(b)
What is the Significance of the Age 70½ Year?
Generally (which means there are some exceptions), you must make a Required Minimum Distribution for the year in which you turn age 70½. The Required Minimum Distribution is the result of a simple calculation: you divide the IRA balance from December 31st of the preceding year by a Life Expectancy. The main complexity of the Required Minimum Distributions rules derive from the determination of that life expectancy. The IRA distribution rules also depend on whether the owner of the Traditional IRA has reached what is known as the Required Beginning Date. The Required Beginning Date is April 1st of the calendar year following the year in which the owner reaches age 70½. If the owner dies before the Required Beginning Date, the distribution rules are different than if he dies on or after the Required Beginning Date. The discussion here will focus primarily on what happens if the owner lives at least until his Required Beginning Date.
What are the Required Minimum Distributions for Roth IRAs?
Roth IRAs are not subject to the lifetime Required Minimum Distribution rules since no distributions are required during the lifetime of the owner. However, Roth IRAs are subject to Required Minimum Distributions rules after the death of the owner of the Roth IRA with a 50% penalty if such distributions are not made. The IRS released its interpretation of the Roth IRA Required Minimum Distributions rules in Article V of IRS Form 5305-R (Roth Individual Retirement Trust Account). That form is a model trust agreement that most financial institutions are likely to use (or to incorporate in their own agreements).
The model agreement from the IRS provides for an automatic spousal rollover if the spouse is the sole beneficiary of the IRA. That means the surviving spouse automatically would become the new owner of the Roth IRA upon the death of the original owner. Note: The surviving spouse would need to name their beneficiary as soon as possible after the death of the original owner in order for the rollover to be beneficial. If a Roth IRA Agreement does not provide for a spousal rollover, a surviving spouse would still have the option to elect to rollover the Roth IRA to become the new owner. Why would you want to accomplish a spousal rollover after the death of the original owner? If the surviving spouse becomes the new owner, there will no requirement for distributions to be made during the life of the surviving spouse! That will result in additional tax-free growth of the account during the surviving spouse's lifetime. A surviving spouse could take distributions as a beneficiary, but there would rarely be any benefit to doing so.
Let's assume the owner (whether the original owner or the surviving spouse who has accomplished a spousal rollover) of the Roth IRA has died and that a beneficiary who is not the spouse is now subject to Required Minimum Distributions rules. The beneficiary will have to take out the entire balance by December 31st of the year containing the fifth anniversary of the owner's death or the beneficiary will have to start taking distributions over the beneficiary's life expectancy starting no later the December 31st of the year following the year of the owner's death. If distributions to the beneficiary do not start by December 31st following the year of the owner's death, the rule requiring a complete distribution of the plan balance within five years will become effective. So it is very important to properly start distributions in the year after the owner's death if one wants to be able to take best advantage of the Roth IRA. Generally, a written election to this effect should be filed with the plan administrator as soon as possible.
A beneficiary would be well-advised to try take advantage of the ability to take withdrawals from the inherited Roth IRA over their life expectancy. The funds in the Roth IRA will continue to grow and compound tax-free while still part of the Roth IRA and the distributions from the Roth IRA will be tax-free as well. Imagine having an account that grows tax-free during your lifetime and pays you tax-free amounts on a yearly basis! That is what a Roth IRA can be to your heirs, such as your children and grandchildren. This after-death tax-free growth is sometimes referred to as the stretchout IRA concept. It is generally considered to be one of the two most valuable aspects of a Roth (the other being the post-70½ tax-free compounding). While Traditional IRAs also have a stretchout aspect, their tax-deferred stretchout is considerably less valuable than the tax-free stretchout offered by the Roth IRA.
How are Required Minimum Distributions calculated for the beneficiary of a Roth IRA? Let's assume a Roth IRA owner who was born on January 1st dies at the age of 90 and leaves the Roth IRA to a child who becomes 60 years old during that year. The child would have to take their first distribution in the year after the owner's death or in a year when they would be 61. The single life expectancy from the IRS tables for a 61 year old is 19.2 years. So in that year they would have to withdraw an amount equal to the preceding year's December 31st balance divided by 19.2. The next year, they would reduce the life expectancy value by 1 to 18.2 and then by 1 to 17.2 in the following year and so on. This is the same Term Certain Method referred to earlier.
The Term Certain Method is the only method available to a beneficiary who is not the spouse. One attribute of this method is that it does not depend on the beneficiary's actual life expectancy. If one lives long enough, the entire balance will have been distributed. If one dies before the end of the payment period (effectively a 20 year payout period in the example), the payment stream could continue if the funds are not fully withdrawn earlier. Note: Some IRA Agreements require a full distribution after the death of the beneficiary.
The Roth IRA Required Minimum Distributions rules are considerably easier than the incredibly convoluted distribution rules for Traditional IRAs. The possibility of making mistakes is lessened considerably thus reducing the chances of expensive mistakes. And longer periods of tax-free compounding will generally occur with the Roth IRA. The biggest problem with the Roth IRA Required Minimum Distribution rules is that the beneficiaries may not be aware of their requirement to make such distributions. Anyone who starts a Roth IRA would be well advised to inform the beneficiaries that they must make distributions after the death of the owner or be prepared to pay a 50% penalty on amounts that should have been distributed. Of course, beneficiaries of Traditional IRAs have the same concerns with the addition of much more complexity. As far as the distribution rules are concerned, the Roth IRA is an easy winner when compared to a Traditional IRA.