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Older boomers face IRA withdrawals or a 50% tax

The first baby boomers are turning 70 this year. That means they soon will have to take a required minimum distribution from their traditional IRAs and 401(k) plans.

The stakes are high for getting RMDs right. If you don't make the appropriate withdrawals, you may have to pay a 50 percent tax on the amount that was not taken out as required.

The Internal Revenue Service uses a formula to determine the RMD for each tax-deferred retirement account you have, based on your age and account balance. The IRS provides worksheets, and the Financial Industry Regulatory Authority offers a free calculator to figure out your annual RMD.

Many IRA providers, such as Vanguard, Fidelity and T. Rowe Price, will automatically calculate RMDs for account holders and transfer that money to other savings or retirement accounts.

Generally, you have to start taking withdrawals from your traditional IRA, SIMPLE IRA, SEP IRA or retirement plan accounts when you reach age 70 ½. If you are still working, some 401(k) plans allow you to defer RMDs from those plans until you retire.

You catch a break on your first RMD, which is due in the year in which you reach age 70 ½. That means if you turn 70 ½ this year, you have until April 1, 2017, to make your first withdrawal.

However, if you defer taking your RMD in the year you reach age 70 ½ until the next year, you will need to take two RMD amounts in 2017. After your first RMD, you will have to take an RMD every year from your retirement accounts by Dec. 31.

If you have multiple IRAs, you have to calculate the RMD for each tax-deferred account and then you can take the total RMD from one account. If you have multiple retirement plans, you will have to take an RMD out from each plan, so it may benefit you to consolidate those assets into one IRA.

Inherited IRAs are a special case. You have to take an RMD for inherited IRA assets by Dec. 31 of the year after the year of the original owner's death. That's even true with inherited Roth IRAs, which don't require RMDs of their original owners.

Avoiding RMDs

Financial advisors recommend several strategies for helping clients minimize their RMDs:

  • Convert to a Roth IRA. Owners of Roth IRAs aren't required to take an RMD. Many clients avoid or reduce RMDs by converting a significant portion of their traditional IRA or 401(k) assets to a Roth IRA, which is funded with after-tax income. That strategy is especially valuable in "potentially low-income years after retirement, but before people claim their Social Security benefits and turn 70 ½," said Nate Wenner, a certified financial planner in Minneapolis.
  • Buy an annuity. Under IRS rules approved in 2014, you can purchase a Qualifying Longevity Annuity Contract (QLAC) with your RMD. You can buy an annuity from your IRA or retirement account tax-free as long as distributions begin at age 85 and you use up to the lesser of 25 percent of your retirement account balances or $125,000. The QLAC will also lower your RMDs and help protect you from outliving your savings. Though the returns from QLACs, currently 2 to 3 percent per year, are far less than what retirees usually earn from dividend-paying stocks and other investments. QLACs are "a very conservative, low-return option," said Hersh Stern, publisher of the Annuity Shopper Buyer's Guide.
  • Give to charity. "Since RMDs are fully taxable, we try to encourage clients who are already giving to charity or churches to gift their RMD directly to qualified charities and bypass the tax recognition," said Amy Hubble, a certified financial planner in Oklahoma City. This strategy is known as a Qualified Charitable Distribution (QCD). For years the status of QCDs was in flux as Congress battled over tax policy until the Protecting Americans from Tax Hikes Act of 2015 finally made the distributions permanently tax-free.

Replacing the 4% rule

Of course, you don't have to minimize your RMDs if you don't want to.

Using RMD guidelines works better as a withdrawal strategy for retirement accounts than the more common 4 percent rule, an old investment rubric that recommends investors take out 4 percent plus inflation adjustments from their retirement accounts each year, according to a 2012 study by the Center for Retirement Research at Boston College.

"The 4 percent rule is pretty dreadful," said Anthony Webb, the study's co-author who is now research director of the Retirement Equity Lab at the New School's Schwartz Center for Economic Policy Analysis. "For average investors, they should just follow the RMD tables and they will be OK."