When you turn 70 1/2, you have to start making required minimum distributions every year from your traditional individual retirement account. If you inherit an IRA, you usually begin these distributions within a year of the owner's death. If you take out less than your required minimum distribution, or RMD, for the year, you pay a 50 percent fine on the rest. If your RMD is $4,000, say, and you only withdraw $1,000, you would pay $1,500 in penalties on the $3,000 you should have withdrawn.
You don't have to take an RMD the year you turn 70 1/2. Instead, you can postpone your first RMD as late as April of the following year, which also postpones having to pay taxes on it by a year. If taking the RMD in the first year would push you into a higher tax bracket, that may work out well. You will have to make the second year's RMD as well that year, so your income that year will be higher by that amount.
Rolling over a traditional IRA into a Roth IRA results in a big tax hit now in return for lower taxes down the line. You pay tax on everything you convert to a Roth, except for any after-tax assets in the IRA. The Roth has no RMD, however, and any withdrawals you do make in retirement are tax free. If your Roth does well, the taxes you save on withdrawals may more than make up for the taxes you pay on the rollover.
If you're older than 70 1/2, using your RMD as a charitable donation eliminates the tax. Suppose your RMD for this year is $2,300: If you have the account manager send some or all of the money to the charity of your choice, there's no tax on the donation. If you're younger, Fidelity Investments suggests you combine rollovers and donations. If you roll over $10,000 to a Roth and donate $10,000 to charity, the write-off would cancel out the added income from the rollover.
If you have unconventional investments in your IRA, it's important to value them accurately when you start taking RMDs. The RMD is based on the worth of your account, divided by your life expectancy on the Internal Revenue Service tables. Suppose your IRA invests in real estate: If the IRS decides the real estate is worth $10,000 more than you think, your IRA is worth $10,000 more to the IRS and you need a larger RMD than you actually took.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.