Episode 22: Rules Make It Daunting - The Facts About RMDs

In this episode, Roger and Jake discuss the SECURE Act 1.0 & 2.0. There are major changes to RMD ages, inherited IRA rules, Roth distributions, and more—and the penalties for getting it wrong can be steep.

If you have a 401(k), IRA, or inherited account—or if you’re managing retirement planning for a parent or spouse—this episode is a must-watch.

To Play This Episode On Your Preferred Podcast Source, please click the icon below:

Welcome to episode 22 of the Life and Finances Together podcast. Well, we've got quite an interesting topic to dive into today! It's important to financial planning and worth unpacking because Required Minimum Distributions (RMDs) are just that, required. But they're also marred by rules that make them daunting. So, let's figure these out together.

You know they always say that there's two things for certain in life: death and taxes. Well, let’s give you one more. The government, or the IRS, making things more complicated. That's pretty much a given as well. And one of those complications is RMDs and two acts.

And this is probably the only time that the government hasn't done anything where it's complicated. Because they did us a favor when they called the first act the Secure Act and then the second act called Secure Act 2.0.

So, we thank you for that and making it a little bit less complicated. But there were a lot of changes between the two acts. As soon as you stop looking at the acts’ titles and you flip over the page to see what they wrote into law, then it starts to get complicated. RMDs used to be such a simple thing that have now become convoluted.

It used to be very simple. You would start taking RMDs at 70 and a half, with early withdrawal penalties at 59 and a half. In the year that you turn 70 and a half, or the year following, you'd look at a table called an RMD table. There's a lifetime table and then a joint life table if your spouse is more than 10 years younger than you.

But basically, you find the factor on that table, divide your year-end IRA balance by that number, and that's what you have to withdraw in the following year. Pretty simple. Secure Act 1.0 changed that RBD, "Required Beginning Date," from age 70 and a half to 72.

Not a lot of changes but still fairly simple.

Now comes the Secure Act 2.0. If you were born in 1959 and before, the required beginning date is 73. If you were born in 1960 or later, now it's 75. So that's one layer of confusion that you have to pay attention to.

But on top of that, now we've got three different types of beneficiaries for inherited accounts that need to be defined.

The key thing here is these are for inherited accounts.

The three types of beneficiaries are eligible designated beneficiaries (EDB), non-eligible designated beneficiaries (NEDB), and non-designated beneficiaries (NDB).

Of the three designations, the EDB, eligible designated beneficiary, is the most common.

The EDBs are surviving spouses, minor children, disabled beneficiaries, those that maybe have a chronic illness, and those that inherit that are not more than 10 years younger than the account owner of the IRA. When you're looking at the EDB, as it relates to a spouse, the spouse still has this capability of taking that IRA from their deceased spouse and rolling it to their own IRA.

And the unfortunate part in our industry is that it's just blindly done. We have to do a little bit more work on this to make sure that rolling it to the surviving spouse is the right thing to do. You're going to have to look at what your income needs and the ages of the deceased spouse versus the surviving spouse.

Let’s give an example: A deceased spouse was over the required beginning date. This age of 73 or 75 and they are subject to taking RMDs. And the surviving spouse, let’s call her Jane, is younger and may not be subject to taking RMDs. If that's the case, maybe what she's going to do is roll it to her own name. If she doesn't need the money, doesn't need to take the RMDs, it would make sense for her to roll the money into her own account.

Conversely, let’s say she’s under 59 and a half and she needs the money to supplement her income after her spouse passed away. If she were to roll the money into her own account, she would be subject to early withdrawal penalties. But her spouse was over 59 and a half and could take withdrawals without any penalty and only have to pay the taxes. If that was the case, then we leave that IRA in the deceased spouse's name because we can get access to the money without penalties. But she’d still have to pay the taxes. There's no way around that.

So, you're going to have to look at several factors. How does this income affect Social Security benefits? How does it affect Medicare premiums? We’ll get to those in a little bit.

Let’s move from EDB to the NEDBs. The non-eligible designated beneficiaries. This is where it gets really complicated for these inherited beneficiaries.

Because of the Secure Act 2.0, whether you inherit IRA money or Roth IRA money, you have to abide by a 10-year rule where all the money has to be depleted and withdrawn from the account 10 years following the year of death of the original account owner. Before Secure Act 2.0, if you inherited money from a non-spouse, which would now categorize you as NEDB, you could stretch the withdrawals over your lifetime.

Now, if you’re an NEDB, the stretch is gone. You have to withdraw the money in 10 years regardless of whether it's IRA or Roth money.

You know the phrase “the Lord giveth, the Lord taketh away?” The same thing applies here. The IRS giveth, the IRS taketh away because it can cause a tremendous amount of tax implications for your financial plan.

Let's say that you inherit a million dollars. You have to withdraw a million dollars from an account that's pre-tax money in 10 years. Let's just say you did it evenly over the 10-year period.

You withdraw $100,000 a year of this taxable investment ordinary income, that's going to cause your tax bill to skyrocket. You're very likely going to get pushed up into a higher tax bracket.

Are there ways that we can try to plan around this? Yes, but because the stretch is gone, we don't have as much time where you can plan around this tax situation from inheriting IRA money. That's why for the beneficiaries it's a lot more beneficial to inherit Roth money from you.

So, one of the things that we're talking about, along with other aspects of the benefits of converting to Roth, is it’s also beneficial for your beneficiary to inherit Roth money from you because even though you're subject to this 10-year rule on inherited Roth money, you don't have to take any money out until the 10th year.

So, we often recommend delaying until the 10th year to get 10 years of tax-free growth, not tax-deferred, in this Roth IRA. Then just deplete the money out in the 10th year. There is a lot more flexibility with the Roth and you don't have those tax implications.

Again, with IRAs, not only do you have to abide by this 10-year rule, but you may also have to take required minimum distributions every year, too.

You could say, hey, I just want to wait until the 10th year to take all this money out of the Roth. Well, you might not be able to. What you have to look at is what's called the at-least-as-rapidly rule.

To put it into layman's terms, you have to look at who the original IRA account owner was and if they were taking RMDs when they passed. If they did, the new beneficiary must take RMDs as well. The way that we like to put it, once the RMD faucet turns on, you cannot turn it off.

Let’s reiterate that; once you turn the RMD faucet on, it cannot be turned off.

If you inherited money from your grandparents and they were taking RMDs, you have to take RMDs every year and withdraw the whole account in a 10-year period. The RMDs probably are not going to be very big, but you have to realize some of this taxation from taking these distributions in this 10-year period.

There are a lot of complicated rules around RMDs and inherited accounts, which is why the IRS may have become a kinder, gentler IRS. Because if you didn't take their proper amount of RMD, the penalty used to be 50% of what you were deficient plus the taxes on top of it. Well, now they've said, “okay, we're going to lower that.”

Now if you make a mistake, we're going to take it from 50 down to 25%. And because the IRS knows what we’ve been talking about is complicated, they will reduce the penalty to 10% if you catch your mistake within two years. So, if you do make a mistake, it’s not as bad as it could be.

How to calculate your RMDs has also become a source of confusion. You no longer can reference the table like you've done in years previously. Now, you reference the table and use what's called the minus one method, where that factor will change and be reduced by one.

What that ends up doing is taking a little bit more out each year in that 10-year period, but still, you have to coordinate how we're going to withdraw this money if you're inheriting this pre-tax IRA money. And when you're looking at that table, it's the factor every single year based upon your age and then you do what? Minus one.

So, now let’s add a little more confusion in the mix. Here's a new scenario; Mom passes away. Her son inherits the IRA. Now he’s subject to the 10-year rule. After three years of taking the RMDs off this inherited IRA that he has, the son unfortunately passes away and the IRA now goes to his wife. So, you would assume that resets the clock and starts a new 10-year rule.

That’s not how it works. The son had already taken out three years’ worth of RMDs. What is the wife responsible to do on inherited his IRA? Deplete the account in seven years. She doesn't get a start over.

All of this is based on when the original account owner passed, and who the initial beneficiary was. The son inherited from the mom as a non-eligible designated beneficiary. That starts a 10-year rule that does not reset.

You can say, “well, a spouse just inherited from a deceased spouse. That makes her an eligible beneficiary designee; can't she stretch it and roll it into her own IRA?”

No, this is totally different because it started out as inherited by him. The original account owner was the mom. It passed to the son. He was three years into the 10-year rule. Now his wife has seven years to complete the remainder of that 10-year rule. Again, layers upon layers of complexity to this.

Which is why financial professionals like us are here to guide you. So that you don't have to worry about this. You don't have to stay up at night wondering, “oh my gosh, am I abiding by these rules? Did I do the minus one method? How many years am I into this 10-year period?” Well, that's what we help our clients track so they don't have to worry about it.

Now let’s look at the last beneficiary designation: non-designated beneficiary. These are estates, charities, and what we call non-qualified trusts. They’re the easiest one. And that beneficiary classification is subject to the five-year rule.

And if you have a trust that's designated as a non-designated beneficiary, you're going to want to make sure that within that trust document that you have a see-through provision. That's going to allow the distribution of the proceeds to be done the way that you want it.

Which is important and something that we really need to underscore because if you’re someone with young children, from an estate planning perspective, you want to list the trust as the beneficiary. Well, if you don't have this see-through provision, now you run into some issues not only with the amount of time that you have to liquidate the account, but it's also the taxation. You're not taxed as a single tax filer at this point. You're taxed on trust tax brackets. And there's a lot of planning challenges here.

You have to make sure that you're looking at the timing of the income and the RMDs that you're taking. If you're retired and already participating in Medicare, what is this additional income going to mean to your premium for your Medicare Part B? You're going to want to make sure you understand and look at that.

You’re going to want to make sure that you adjust your cash flow with this additional income because some of these premiums may rise on Medicare or your tax bracket. Some people also say, “you know what I'm going to do? I'm going to take the RMDs and I'm just going to wait until the 10th year and cash it out.”

You might not want to do that. In most cases, you're going to take this huge lump sum and you’re going to be taxed at potentially the highest tax rate possible. So, you're going to want to schedule the withdrawals out and coordinate with your tax bracket to try to minimize what the tax bill could be in each year for that 10-year period.

Now that doesn't relate to Roth IRAs. With a Roth, you really do want to wait until that 10th year because you have time. You have that time where you can keep the money in the Roth IRA, get that tax-free growth for 10 years minus one day and then take the money out to satisfy the 10-year rule. This way, you can get tax-free growth and don't have to take portions out each year of that 10-year period.

Now there's also been an elimination of RMDs for Roth 401ks. Originally if you were

75 years old - so it's all encompassing based on the different required beginning date changes - if you have pre-tax money in your 401k and you had Roth money in your 401k; you had to take RMDs out of those accounts. Now, because of Secure Act 2.0, if you're still working beyond this required beginning date and actively contributing to your 401k plan, regardless of if it’s pre-tax or Roth money, the IRS will allow you to delay taking RMDs from your 401k account.

The last thing we want to touch on is these things called QCDs. There's one more acronym for you. These are Qualified Charitable Distributions. The $100,000 annual QCD limit is going to be adjusted for inflation now. There’s some planning that you can do with that in making these donations to charities.

There are so many things that are going on with these RMDs, we’ve just scratched the surface.

Maybe RMDs don't even apply to you yet, but you should probably understand how they work whether it's for you down the road or a family member that you're caring for. You need to understand these rules and if it gets a little too complicated, which a lot of times it does, you're going to want to get some professional help. And make sure that you're incorporating your options into your financial plan. Looking at this from the standpoint of what are my alternatives and what is the impact going to be when we do the math on our financial plan calculations? Understand all these different types of beneficiaries, understanding the rules, the tables, the calculations, what the tax impact and the penalty impact is.

And this needs to happen before you retire. Until you've done that, you really haven't brought life and finances together.

Thanks so much for reading along with us to learn more about required minimum distributions today. For questions about our financial services or finances in general, send us an email, give us a call, and of course, please like and subscribe to our podcast and stay tuned for our next episode.