In this episode of Friends Talk Financial Planning, John and Bridget discuss the required minimum distributions (RMDs) and the recent changes to penalties for not taking them. They dive into the details of the Secure Act 2.0 and provide important tips to avoid IRS penalties.
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TRANSCRIPT:
John: Do you remember the rule from the Secure Act 2.0 that came out earlier in the year that affects required minimum distributions and changes the penalties for not taking them? In this episode of Friends Talk Financial Planning, we're going to revive that topic and talk about things that you might need to do before the end of the year to avoid getting stung by IRS penalties. Hi, I'm John Scherer and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois. John, before we get started, let's remind everybody to subscribe. It helps us find more viewers with YouTube. Okay, so, John, let's talk about the Secure Act 2.0 and required minimum distributions, otherwise known as RMDs.
John: That's right. Let’s get out our acronyms. The IRS issues RMD rules, and we'll talk about some QCDs and other FYIs as we go through.
Bridget: And TLAs😊
John: We had a couple of episodes when Secure 2.0 came out. This was a very wide-ranging act, and a lot of things didn't take place. And it's easy to kind of forget that it wasn't that long ago. And some of those things are in place right now. And the one thing that I wanted to talk about here today is the required minimum distributions. And I think most people are aware, but if you're not, when you have IRAs and you're over a certain age, you have to start taking a certain percentage of that money out of your IRA and pay taxes on it.
And effectively what happens is the IRS lets us defer taxes. You put money into your 401K or 403B, and you can take a tax deduction for it. It grows. You don't pay any taxes. And they say, “Hey, at some point you have to take the money out, so we can start getting our tax dollars.” And what's the first year? It's something like 4% or 5%. There's a scale and a percentage, but there's some number, and then it goes up over time, and so you have to take that money out.
And the IRS has had a long-standing rule that said, “Listen, if you don't take the required minimum distribution amount out each year, then there's a penalty.” And the penalty had been 50% of the amount that you had to take out. This is just background. We're not even to the Secure Act 2.0 yet, but what does that mean, right? If I need to take out $10,000 from my IRA this year because I'm over the age limit, if I don't do that, the penalty is 50%, so I have to take out the $10,000, pay $5,000 in penalty, plus pay regular taxes on all that. That’s a pretty severe penalty.
Bridget: It’s among the highest IRS penalties that there are. You're one day late, and it costs you 50%.
John: That seems kind of crazy to me. And of course, if you're cheating the system or intentionally doing things, that makes sense, but people make mistakes and to have a mistake punished by a 50% penalty is very extreme. And we'll talk about this in a little bit, but oftentimes when people did make mistakes and didn't take it out, if you basically went to the IRS and said, “Jeez, I'm really sorry, I didn't mean to do it, here's why it happened, it won't happen again,” almost all the time, they would forgive it. I don't know if I've ever heard of any time where they haven't forgiven that penalty saying, “Yeah, you just screwed up. You're not trying to cheat the system.”
Then the Secure Act came out, and years ago it was 70 and a half when you had to start taking money out, then it was 72, now Secure Act says it starts at age 73. It's going to go up for a couple of years. But now, if you're 73, you have to take these RMDs. There're a couple of exceptions, but basically the year when you turn 73, you have to take your RMD. So now we're in this spot where you have to take your RMD if you're turning 73 this year or you're older than that. And if you don't take it out by the end of the year, there's still a penalty. But now they've changed the penalty, and instead of 50%, now it's 25%.
Bridget: John, I want to interrupt you, because I was talking to a client this week who is turning 73 next year. She's turning 73 in 2024, and they still have that extra time rule, so she has until I think it's April 2025, because the first year of her RMDs. I told her I'm not going to recommend that we wait, because then I think you're going to need to take two in that year…
John: That's right.
Bridget: …which you don't really want to do. But that part is still in play, and I wasn't sure of that until I looked it up this week.
John: Yeah. And that's one of those exceptions. For the first year, you can push it off until basically before your tax return, but then the next year, you don't have that exception. Next year it's going to be double dipping, which for some folks might make sense. Golly, maybe you sold an investment property, and you don't want to pay extra taxes this year, so you push it off till, effectively, your age 74 year. It can fit in, but it's the minority of folks.
Bridget: Yeah. It's not generally the plan.
John: Yeah. Thanks for bringing that up, Bridget. So you have to take money out and if you don't now they've reduced the penalty, which sounds awesome, and it is with a couple of caveats. So now one of the rules says that if you make a mistake the penalty is 25% but if within two years you make it right, you correct it, then the penalty goes down to 10%. And so certainly at first blush, I think it is better. But think about what we're talking about. Hey, we made a mistake. Shoot, I didn't realize I was supposed to do this. I had to take out $10,000. I fixed it. Mea culpa. I go back to the IRS and say, “We did this.”
Now the penalty is a default 10%, which in our example of $10,000 required minimum distribution, that's still $1,000 penalty on top of the taxes. I mean, that ain't cheap, right? That’s better than 50% but it sort of lays this default in here and it makes it sort of feel like maybe the mentality or the approach the IRS is going to be taking is, hey, let's not be quite so forgiving. When the penalty is 50%, that's draconian. We don't want to punish people too much, so we'll always err on the side of the taxpayer. Now at 25% you go, “Hey, it's half as much, maybe they're going to start enforcing that.”
And especially if within two years, it's only 10%. People in our world are saying, “Yeah, now a mistake might actually cost you some money,” as opposed to, “Jeez, it's almost the get out of jail free card when you say, ‘Hey, I screwed up.’” Maybe that doesn't carry water anymore. We don't know that. It's not like that's a fact, but this new change doesn't make it less meaningful that make sure when we say, “Make sure you get your RMDs done before the end of the year.” Now even though the penalty is a little bit lower, I sort of feel like double make sure that you do this because I'm not sure that there's going to be any forgiveness going forward. Not sure what your thoughts are on that.
Bridget: I totally agree because it seems to me like we should ask, “Why did they change this?” You have to wonder.
John: It’s not out of the blue. There was some reason for it.
Bridget: Yeah. And so, who motivated this change? Why go for this change? And on its face, it seems to be taxpayer friendly, but I wonder if the IRS wasn't lobbying for this, saying, “We want to start actually getting something out of this.” And they were probably handling a lot of mea culpa forms that they were just pretty much routinely forget saying, “Okay, you're fine, we'll waive the penalty.” So maybe they wanted to reduce that paperwork, but at the same time start getting some more penalties. That explanation makes sense to me.
John: It's all speculation. We don't know that. And it doesn't really change any much. In the old days, you had to take out your RMDs. Don't cheat the system. Now you have to do it too. But it's sort of like saying, “REALLY don't forget,” even though we never tried to do it in the other side of things, maybe this might be a good spot to clarify what we are talking about with these RMD. How do you figure it out? What goes on with that? The value of your minimum distribution is based on the end of last year.
So as of 12/31, that value is used to calculate your minimum distributions. And most custodians (we both use Schwab) will tell you on their website, “Your minimum distribution for this year is X number of dollars.” So you can go on there and see that. And if you use Schwab, it'll tell you, “You had to take out this much, and so far, you've taken out that much,” so if you have a question after watching this and go, “Jeez, did I do this?” Go back in and check. You should be able to see it right there, whether you've done it or not, before the end of the year.
Bridget: And that seems like you would know, but one of the strategies we use with a lot of clients is a qualified charitable distribution, or QCD. So if you're over 70 and a half…
John: Yes, that’s still the case.
Bridget: …Schwab will send you a checkbook, and you can make your charitable contributions to a 5013C from this checkbook. And that's called a qualified charitable distribution. The great thing about it is it counts towards your RMD or your required minimum distribution, but it’s not without its few challenges, too. So you don't necessarily know when those checks have been cashed. So that's why it's nice to see that number and say, “Okay, what's run through? How many charitable contributions have I made?”
John: Yeah. That's a great reminder. And sometimes it gets confusing. I have the RMD and the QCD. Are they the same thing? They're not the same thing, but they are related. Here's an example. We just used this to explain to a client sort of how it worked. Again, I need to take out $10,000 from my IRA this year. That's my required minimum distribution, or RMD. I want to send $3,000 to United Way as a charitable donation. I write that check out of the IRA account. It goes right to the charity, no taxes required of me. I need to take out $10,000. I've taken $3,000 and given it to United Way.
Now I need to take out $7,000 and pay taxes on that to satisfy the rule. So the QCD and the withdrawal sort of add up to that RMD or Required Minimum Distribution level. And you said about getting the checks cashed also, that's the other critical thing is when you do those charitable distributions from an IRA, it's not when you write the check but when the check is cashed. Thus, the checks have to be cashed by the end of the year in order to qualify. So that's the other thing. This is a 12/31 deadline. It's not a tax time deadline like saying make your IRA contributions before you file your taxes or those sorts of things. There is a deadline on this that people need to be aware of.
Bridget: Right. And I advise clients to make contribution or charitable contributions out of there from QCDs before December 1st because you would think that these charities would be on it with depositing the checks, but a lot of times, they're not, so giving them a month helps. And then just double checking it is great.
John: Yeah. Well, I think that's a great place to wrap things up. There are some changes coming in this year with the new Secure 2.0 regarding minimum distributions from your IRAs. Make sure you take your minimum distributions here before the end of the year. And with that, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. We're both proud members of ACP, or the Alliance of Comprehensive Planners, which is a group throughout the country of fiduciary, tax focused comprehensive financial planning. Both John and I are taking clients, but if you're interested in an advisor near you, you can check out acplanners.org.
John: And don't forget, hit that subscribe button.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.