While the U.S. government wants to encourage individuals to save for retirement by providing tax incentives for using the IRA structure, they don’t want to forego the tax revenue entirely. For example, you’ll potentially be able to take a tax deduction for contributions you make to a traditional self-directed IRA, and won’t have to pay taxes on any investment growth or gains that occur and remain within your account, but you will have to pay taxes when you make withdrawals from your account.
One important way that the IRS rules manage the balance between allowing tax breaks for retirement savings, but requiring that the account holder pays taxes at some point, is the set of rules on required minimum distributions (“RMDs”).
RMD Basics. Once a traditional IRA account owner reaches age 70½, they must begin taking distributions from their account, and those distributions must meet certain minimum amounts that are calculated based on the account balance and the account holder’s age. The account holder must withdraw the calculated minimum amount from their account every year.
It’s important to note that because the required minimum distribution amounts are only minimums, the account holder is always free to take larger or more frequent distributions from their account.
It’s perhaps even more important to understand that the RMD amount will almost certainly change from year to year. Because the calculation is made on the basis of the value of your account at the end of the year, your investment performance over the year will change the amount upon which the amortization calculation operates.
Special Considerations for Some Investments. Your RMD obligations do not take into account the composition of your traditional self-directed IRA. If you happen to have an account that is comprised of illiquid investments, you’ll still need to take an appropriate distribution, even if you don’t have the free cash available to do so. You can do this by taking a distribution of illiquid investments that have a fair market value that’s at least as much as your RMD amount, or you can distribute the asset itself. This might be desirable if the asset is a vacation property or some other asset you’d like to make personal use of during retirement.
But taking a large distribution in one year won’t get you a credit against any future RMDs in future years.
Roth Self-Directed IRAs are Not Subject to RMD Rules. Note that we’ve only been talking about traditional self-directed IRAs with respect to the rules on required minimum distributions. That’s because the Roth account is not subject to these rules, and account holders are never required to take any distributions, regardless of their age or account balance.
Given the value that this feature has to many individuals, one common way to maximize retirement flexibility is to convert a traditional account to a Roth account. This triggers a tax bill in the year of conversion, but many account holders find the change to be worth the cost.