Individual Retirement Account Distribution Rules and Requirements

With an effort to increase the American retirement savings rate, Congress established Individual Retirement Accounts (IRAs) through the Employee Retirement Income Security Act of 1974.  IRAs have greatly advanced since their creation, allowing for tax-deferred, and in some cases tax-free, growth of retirement assets.  Also, they allow greater contribution limits and catch-up contribution provisions for older participants.

 It is easy to find advice on the contribution rules for IRAs, with little emphasis on the withdrawals.  That is why we will spend our time focused on the distribution rules of assets from your retirement account. Whether you’re taking early withdrawals, normal withdrawals, borrowing or gifting from your accounts or have a required minimum distribution due, you need to be aware of the rules and requirements in order to avoid costly penalties.

 Traditional IRA

 Traditional IRAs grow tax-deferred with the withdrawals subject to ordinary income taxes.  Normal withdrawals from a Traditional IRA are penalty-free starting at the age of 59 ½.  If an IRA owner chose to take an early withdrawal from their IRA, the withdrawal would be subject to both ordinary income tax as well as a 10% penalty.   There are several exceptions to the 10% early withdrawal penalty.  The exceptions include a withdrawal due to the owner’s death, disability or divorce (in order to split the assets with their former spouse), as well as the owner using the money to pay for qualified education expenses, medical expenses above 10% of their gross income or up to $10,000 for their first home purchase.  Technically, loans from an IRA are forbidden.  However, if money is withdrawn the owner has 60 days to redeposit the money into an IRA without incurring taxes or an early withdrawal penalty. 

Required minimum distribution (RMD) rules apply to Traditional IRAs.  These distributions are the minimum amount the account owner is required to withdraw from their IRA annually starting in the year they turn 70 ½ and must be taken by December 31st of that year.  Account owners do have the option to delay their first withdrawal until April 1st of the following year.  However, this strategy is advantageous only in very limited circumstances.  The RMD amount is calculated by dividing the previous year-end account value by a divisor determined by the age of the account owner. If the full amount of the RMD is not withdrawn by December 31st, the shortfall is subject to a 50% penalty. Also, converting part of a traditional IRA to a Roth IRA doesn’t count towards the RMD.

 With the passage of the Protecting Americans from Tax Hikes (PATH) Act of 2015, tax-free Qualified Charitable Distributions (QCD) from IRAs were made permanent.  Under the QCD rules, the IRA owner must be age 70 ½ or older on the date of the distribution, not merely turning 70 ½ sometime that year as under the RMD rule.  Also, all donations must be transferred directly from the IRA custodian to the qualified charity, otherwise the distribution will be taxable.

 The maximum dollar amount of a QCD for any individual is $100,000 per year. For a QCD to satisfy a current year's RMD, the funds must come out of the IRA by December 31.

 Inherited Traditional IRA

 Unlike a Traditional IRA, an Inherited Traditional IRA doesn’t have early withdrawal penalties.  Generally, the owner is required to either take an annual RMD during their lifetime “stretch” IRA or fully liquidate the IRA within five years after the original account holder passed away.  Like a Traditional IRA, most distributions are taxed.  The account is eligible for a QCD, provided the same QCD rules are followed as the Traditional IRA.

 Roth IRA

 Roth IRAs have a few added wrinkles compared to their Traditional IRA counterparts.  First they grow tax-free versus tax-deferred as contributions have already been taxes.  They are not subject to RMD rules.  Tax-free distributions can start at age 59 ½ if the Roth IRA meets the five-year waiting rule.  The waiting period begins on the first day of the first year for which any of your Roth IRAs were funded.  There is a separate five-year waiting rule for each Roth IRA conversion; they start with the first day of the year in which the conversion is made.  The Roth IRA is subject to a 10% early withdrawal penalty.  However, this only applies to the investment earnings portion of a withdrawal.  The original contributions can be withdrawn free of taxes and penalties prior to age 59 ½. Tax rules deem Roth IRA distributions as coming first from contributions, then from investment earnings.  Exceptions to the 10% penalty and the five-year waiting rule are in the case of death, disability, higher education expenses for yourself, spouse, child or grandchild, to pay up to $10,000 towards the purchase of a first home and to pay health insurance premiums if you become unemployed.

 Inherited Roth IRA

 Comparable to the Inherited Traditional IRA, the owner of an Inherited Roth IRA must either take required minimum distributions over their lifetime or a full distribution over a five-year period after the original account owners’ death.  The main difference with an Inherited Roth IRA is that the distributions are tax-free.

 Possible Changes

 Currently, there is a piece of legislation in congress named the SECURE Act.  If passed, it would modify some of the rules and regulations.  One major change would threaten the “stretch” IRA strategy.  As always, Provident stays current on regulatory changes that impact our clients and will provide updates if the rules change.

Dan Krstevski, CFP®