Don't Get April-Fooled by This Very Costly IRS Tax Trap
Fortunately, it's not hard to avoid this IRS tax trap. Later on, we'll show you what you need to do to steer clear of this potential pitfall, but first, let's take a look at why the government puts such a high price tag on complying with this key retirement rule.
When You Have to Start Spending Down Your Retirement Savings
Most people start tapping their savings after they retire, as they look for ways to cover living expenses without the benefit of a regular paycheck. For those who took advantage of tax-favored retirement accounts like IRAs and 401(k) plans to help them save for retirement, the opportunity to take penalty-free withdrawals opens up at age 59½, allowing even early retirees to make ends meet.
Some people, though, prefer to leave their retirement accounts untouched, in part because withdrawals from traditional IRAs and 401(k)s are added to taxable income. To prevent people from choosing never to take money out of retirement accounts, though, the IRS enforces required minimum distribution rules that force you to take withdrawals after you reach age 70½. Specifically, if you're one of the roughly 2 million Americans who turned 70½ at some point during 2014, you have until April 1 to take out a set minimum amount from your retirement accounts. If you don't, then the IRS will impose a penalty equal to 50 percent of whatever you should have withdrawn.
You'd think that the threat of a big IRS penalty would spur people into action. But according to Fidelity Investments, as of Dec. 26, 2014, almost three out of every five accountholders who turned 70½ during the year hadn't yet taken the correct amount, and a quarter of accountholders hadn't yet taken any withdrawal at all.
How Much Do You Have to Withdraw?
Where things get complicated is in figuring out your required minimum distribution. The IRS uses life-expectancy tables to calculate the fraction of your retirement-account balances you need to withdraw each year, with the amount generally increasing the older you get.
Confusingly, while the tax laws hinge on age 70½, the life-expectancy tables work in whole years. If you turned 70½ and hadn't reached your 71st birthday by the end of 2014, then your life expectancy is 27.4 years, and so you'll have to withdraw a percentage equal to 100 percent divided by 27.4, or 3.65 percent. If you turned 70½ early in the year and were 71 by year-end, then the corresponding figures are 26.5 years and 3.77 percent.
Once you have the correct percentage, you then multiply it by the total amount you had in your retirement accounts coming into 2014. For these purposes, you'll take the balance as of the last day of 2013. So if your IRA and 401(k) balances added up to $100,000, you'd have to withdraw $3,650 or $3,770, depending on whether or not you'd reached your 71st birthday by the end of the year.
In subsequent years, you'll need to take your required minimum distributions even earlier. The April 1 deadline moves up to Dec. 31 every year except the first one in which you're required to take RMDs.
April Fool's jokes are supposed to be funny, but a 50 percent IRS penalty is nothing to laugh about. If you were born between July 1943 and June 1944, be sure you check to make sure you've made the right withdrawal from your retirement accounts.
Motley Fool contributor Dan Caplinger isn't close to needing to take required minimum distributions, but he does hope to retire someday. You can follow him on Twitter @DanCaplinger or on Google Plus. Check out our free report on one great stock to buy for 2015 and beyond.