Beware the 50% penalty on ira required minimum distributions!

As 2007 comes to a close, there is one particular IRA issue that you may need to be aware of. If you have reached age 70 ½, you are generally required to start taking mandatory distributions from your IRA’s, 401k’s, and other employee retirement plans. This is of critical importance because the penalty for not taking Required Minimum Distributions (RMD’s) is 50% of the amount that should have been taken. This is by far the harshest penalty the IRS has in it’s arsenal.

One of the major benefits of IRA’s is tax-deferred growth of your money. This benefit can only last so long however because the IRS wants their cut. This is why there is a Required Beginning Date (RBD), which is when you must begin withdrawing from your Traditional IRA. Taking your first RMD can be confusing because the rules for the first year are slightly different from subsequent years. The date you must begin RMD’s is generally April 1^st of the year following the year you turn 70 ½ years old. So if you turned 70 ½ at anytime during 2006, your Required Beginning Date (RBD) is April 1^st, 2007. If you miss a required distribution, the penalty is 50% of the amount that you should have withdrawn.

This first distribution is tricky because many people make the mistake of not withdrawing enough in the first year. Suppose Bob Smith has a Traditional IRA and turned 70 ½ in 2006. This means his RBD was April 1, 2007 in which he was required to take his first RMD of $20,000. Where many people make the mistake is not taking the current year RMD in addition to the first year. The RMD for each year is generally calculated by dividing the IRA account balance as of the end of the previous year by the life expectancy of the IRA owner. In the case of a first year RMD that is deferred until April 1^st of the following year, this means that two RMD’s must be taken in that year to satisfy the previous and current year RMD. In our example, this means that Bob would need to withdraw $20,000 by April 1, 2007 and another $20,000 by December 31^st of 2007. Of course, the rules are a bit more complicated and each individuals circumstances may be different, so it is important to consult a qualified advisor.

Keep in mind that IRA custodians are required to report to the IRS of all IRA owners who are subject to RMD’s, but not the actual amount. This is a good reason to make sure you are withdrawing the required amount. In addition, since IRA custodians are required to inform you that you must take an RMD each year, it is unlikely that the IRS will waive the penalty if you forget.