A Reminder for Those Turning 70
Seventy can be a watershed age, and not just because you have more candles to blow out. It happens to be one of those birthdays that Uncle Sam cares a lot about. And so it’s one you should care a lot about, too.
When it comes to the Social Security side of the income equation, if you haven’t filed for your benefit yet, you ought to do so a few months before your 70th birthday. You might ask: Why would I delay receiving my monthly Social Security check when I can start as early as age 62? The answer is related to income. If you want to maximize your Social Security benefit, it may make sense to wait. Perhaps you have other sources of income—such as from a job or investments—that can carry you for a few years. Thanks to something called the Delayed Retirement Credit (DRC), for every 12 months past the age you are eligible to fully collect benefits (Full Retirement Age or FRA for short) and you postpone filing for them, your monthly Social Security check will increase by 8%. If your FRA is 66, waiting four years (until age 70) to start taking Social Security results in a benefit that is at least 32% larger. However, Uncle Sam’s generosity comes to a screeching halt when you turn 70. That’s when DRCs stop.
Just to be perfectly clear: There is no upside to delaying the start of Social Security past age 70.
Age 70 and Your Retirement Accounts
Not only is 70 an important milestone when it comes to Social Security, it’s also important when it comes to your retirement accounts. A serious “age 70” mistake would be to forget that you must start taking Required Minimum Distributions (RMDs) from most retirement plans once you turn 70½. In most cases, you did not pay income tax on the money that you contributed to these plans over the years. RMDs are the government’s way to make sure it collects those taxes.
Caution! The rules about required withdrawals are similar, but not exactly the same, for different types of retirement accounts.
For instance, say you have a traditional 401(k) account. If you are 70½ or older, are still working for the employer that sponsors the plan, and you do not own 5% or more of the company, you don’t need to take RMDs until you stop working for that employer.1
In the case of 403(b) plans, which often cover public sector workers such as teachers, police officers and firefighters, there are also required distributions starting at 70½. However, RMDs do not apply to plan contributions made before 1987.2
RMDs are also mandatory for any non-Roth Individual Retirement Account (IRA) to which you made tax-deductible contributions, including a Simplified Employee Pension Plan (SEP), a Salary Reduction Simplified Employee Pension (SARSEP) and a Savings Incentive Match Plan for Employees (SIMPLE) IRA.3
Importantly, there are no required distributions from any type of “Roth” account. This includes a Roth IRA and Roth 401(k). Contributions to Roth accounts are made with after-tax income. Because you already paid tax before making your contribution, the government has nothing to gain by forcing you to take withdrawals from these accounts. Both the amount you contributed as well as all investment gains can be withdrawn when and if you wish, tax-free, assuming you meet the qualifications.
On Your Mark, Get Set …
Say you have a traditional IRA and reached age 70½ this year. Logically, you’d assume you’d have to take your first withdrawal by December 31, right? Wrong. The actual deadline for taking your initial RMD is April 1 of the year after you turned 70½.
If your birthday falls in the first six months of the year—say, March 5—you turn 70½ on September 5. However, if your birthday month is July through December, you will reach 70½ in 2017. In that case, your first RMD is due by April 1, 2018.
After your first RMD, your annual withdrawal must be taken by December 31 of each year.
It’s important to talk to your financial or tax advisor about the timing of your RMD. Waiting until the April 1 deadline to take your first RMD means you will have to take two RMDs that year. This could push you into a higher tax bracket.
Costly Consequences for Missing an RMD
The penalty for not withdrawing the required amount from your account is one of the most severe in the tax code: 50%! This is applied to the shortfall. For instance, suppose your annual RMD is $10,000 but you only withdrew $6,000, which is $4,000 less than required. You could get a notice from the IRS stating that you need to withdraw the additional money. In addition to paying ordinary income tax on the full $4,000, you must also pay an excise tax equal to half of this amount, or $2,000!
The good news is that the IRS is generally very forgiving if you make an RMD mistake. Furthermore, it tends to be more understanding if you bring the issue to its attention before it sends you a letter. You should ALWAYS discuss your personal tax matters with your own tax advisor, but here are steps to consider which may allow you to avoid the 50% excise tax:
- Figure out how much more you should have withdrawn.
- Contact the custodian of your account and ask them to send the amount to you.
- Fill out Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.”
- Send the form to the IRS and attach a brief note explaining the reason you withdrew too little and that you have taken steps to rectify it.
- Never make this mistake again. Repeat RMD offenders are not appreciated.
Calculating the minimum you must withdraw from your retirement account is more complex than it should be. You start with what the account was worth at the end of the previous year, then divide this by something called a “life expectancy factor.” This varies based upon your age and—if you have named one—the relationship and age of your beneficiary. You can find appropriate IRS worksheets to help with this exercise.
If you have named a qualified charity as the beneficiary of your account, you can turn your RMD into a charitable contribution, making as much as $100,000 all or partly tax-deductible. This option was made permanent by legislation enacted last year.
Finally, you can always take out more than the “minimum” amount. Your Required Minimum Distribution is exactly that—the least amount you must withdraw.
Learn more about developing a strategy to fund your own retirement: www.franklintempleton.com/whatsnext.
And, ask your professional advisor to run your personal scenario though the independent third-party LifeYield Social Security Optimizer tool, which can help you determine the right time to start taking Social Security benefits.
Gail Buckner’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Opinions and analyses are rendered as of the date of the posting and may change without notice.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
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1. Internal Revenue Service, https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
3. Source: Internal Revenue Services, RMD Comparison Chart, https://www.irs.gov/retirement-plans/rmd-comparison-chart-iras-vs-defined-contribution-plans