Self-Directed IRA Distribution Rules: Everything You Need to Know
Estimated reading time: 12 minutes
Putting funds in is the hard part. Taking funds out should be the fun part.
At Entrust, we believe that understanding the distribution process is essential to attaining peace of mind with your self-directed IRA (SDIRA). It’s a crucial aspect of transforming hard years of savings into a lifetime of financial security.
In this blog post, we will cover everything you need to know about SDIRA distributions, including required minimum distributions (RMDs) and the difference between cash distributions and in-kind distributions. By learning about each distribution method, you'll gain valuable insights enabling you to make informed decisions with your tax-advantaged funds.
Early distributions may result in penalties and the revocation of the funds’ tax-advantaged status.
An RMD is a mandatory distribution from tax-deferred retirement accounts starting at age 73. Roth IRAs do not have RMDs during the original account owner's lifetime.
If you have enough undirected cash in your SDIRA, making a cash distribution is usually the simplest option. If you don’t have the requisite funds, then you will have to take an in-kind distribution.
IRA distributions do not affect Social Security retirement benefits.
Table of Contents
- What is a Retirement Distribution?
- Avoiding Early Distributions from a Retirement Plan
- What is a Required Minimum Distribution?
- How to Take an SDIRA Distribution
- Cash Distributions vs In-Kind Distributions
- Frequently Asked Questions on SDIRA Distributions
- Handle Distributions with Confidence at Entrust
What is a Retirement Distribution?
A distribution from a retirement account refers to a withdrawal of funds or assets. However, not all distributions are treated equally.
For traditional IRAs and other tax-deferred retirement accounts, distributions are generally subject to income tax upon withdrawal. On the other hand, Roth IRAs are funded with after-tax contributions, and qualified distributions from Roth IRAs are generally tax-free.
Avoiding Early Distributions from a Retirement Plan
To maintain the tax-advantaged status of your retirement funds, specific requirements set by the IRS must be met. If you fail to meet these requirements, the tax-advantaged status of the withdrawn funds will be revoked.
Taking an early distribution (before reaching 59½ years old) from your IRA is one way to trigger this situation, resulting in an early withdrawal penalty of 10%. Additionally, if the funds are tax-deferred, you must also pay income taxes on the distributed amount.
To avoid penalties on SDIRA distributions, it's crucial to adhere to the following guidelines:
Age and Distribution Requirements: Distributions from traditional IRAs and other tax-deferred retirement accounts can be taken penalty-free starting at age 59½. However, for Roth IRAs, you must be at least 59½ years old and meet the five-year holding period.
The IRS provides some exceptions to early withdrawal penalties. These include:
- Higher education expenses
- First-time homebuyer expenses (up to $10,000)
- Qualified medical expenses
- Certain types of disabilities
- And others
Can I Distribute My Roth Contributions Penalty-Free?
The original contributions made to a Roth IRA can be withdrawn at any time without penalties. These funds have already been taxed. Take note, this does not include earnings.
However, account conversions from a traditional IRA to a Roth IRA are subject to a five-year holding period if you wish to avoid penalties on distributions of converted amounts.
What is a Required Minimum Distribution?
A required minimum distribution (RMD) is a mandate requiring individuals with tax-deferred retirement accounts to take a minimum distribution once they reach age 73. The specific amount that must be distributed is determined by age and account value.
The primary purpose of the RMD is to ensure that individuals use their retirement savings for their intended purpose—providing income during retirement—and to ensure the proper taxation of those savings.
Contributions made to traditional IRAs and employer-sponsored retirement plans, like 401(k)s, are typically tax-deferred. This means they are not taxed when originally contributed. From the perspective of the IRS, these funds must become taxable at some point.
Therefore, RMDs require individuals to withdraw a minimum amount each year starting at age 73. After decades of pushing tax bills down the line, the IRS can finally collect.
Do Roth IRAs Have RMDs?
No. Roth IRA contributions have already been taxed, so RMDs are not mandated during the original account owner’s lifetime.
However, if the Roth IRA is inherited by a non-spouse beneficiary, they may be subject to RMDs based on the IRS rules for inherited IRAs. These rules differ based on whether the beneficiary is an eligible designated beneficiary or a non-eligible designated beneficiary.
Eligible designated beneficiaries, such as the surviving spouse, minor children, or disabled individuals, have the option to stretch the RMDs over their life expectancy. Non-eligible designated beneficiaries, like adult children or certain trusts, must empty the account within 10 years of the original account owner's death.
To ensure compliance with IRS regulations, Roth IRA beneficiaries should consult with a tax advisor to understand their specific RMD obligations.
What Happens if I Don’t Take My RMD?
Failing to take an RMD or withdrawing less than the required amount can result in substantial penalties.
The IRS imposes a significant tax penalty on any undistributed amounts, typically 25% of the RMD that should have been taken but wasn't. For example, if your RMD was $20,000 but you only distributed $5,000, you may have to pay up to a 25% penalty on the undistributed $15,000. This penalty is in addition to the regular income tax that would apply to the distribution.
In late 2022, the SECURE Act 2.0 was enacted into law, introducing changes to the penalties for missed RMDs. Previously, the penalty for missed RMDs was 50%. The SECURE Act 2.0 reduced it to 25%. If the error is rectified promptly, the penalty is further reduced to 10%.
To qualify as a timely correction, individuals typically need to take the missed RMD and submit IRS Form 5329 by the end of the second calendar year following the missed RMD. For example, if you failed to take your RMD in 2023, then you would have until December 31, 2025, to take the RMD and reduce the penalty from 25% to 10%.
Important Information For 72 and 73-Year-Old IRA Holders
In addition to reducing the penalties for missed RMDs, the SECURE Act 2.0 also raised the RMD age from 72 to 73.
However, many 72-year-old IRA holders didn’t hear about this change and took an RMD when it wasn’t required. If this happened to you and you completed an RMD between January 1, 2023, and July 31, 2023, you may be able to roll the distributed amount back into your IRA.
You must complete this rollover before September 30, 2023, in order for it to qualify. This rollover is permitted even if you already completed a rollover within the last 12 months. However, it does prevent you from completing another rollover in the next 12 months.
How Does the Required Minimum Distribution Work?
To illustrate how the required minimum distribution works, let’s take 73-year-old Alfred as an example.
Alfred is average in every way, including his retirement savings. This means he has about $425,000 in retirement savings, according to the most recent figures from the Federal Reserve. Having recently turned 73, this is Alfred’s first year having to take an RMD. At his age and account value, this leads to an RMD of about $16,000.
So, Alfred works with his IRA custodian to distribute at least $16,000 from his IRA to his personal savings account. His custodian reports this figure on IRS Form 1099-R, the IRS verifies the amount, and Alfred’s tax-advantaged funds remain in good standing.
How to Take an SDIRA Distribution at Entrust
Whether you’re taking your first RMD or are already well-versed in distributions, taking a distribution with your SDIRA held at Entrust is simple.
- Make sure that you’re ready to take a penalty-free, qualified distribution.
- Log into the Entrust Client Portal.
- Select “Take Distribution” from the Quick Links or “One-Time Distributions” under the “Activity” tab.
- Complete the One-Time Distribution Form.
- We will process the request. Within 5-7 business days, we will finish processing or reach out for additional items that we might need.
If your distribution cannot be completed online, fill out a hard copy of the One-Time IRA Distribution Form or Precious Metals Distribution Form. Submit the completed form to Entrust using one of the following methods:
- Email: Email the completed form to firstname.lastname@example.org.
- Fax: Fax the completed form to The Entrust Group at (510) 587-0960.
- Mail: Mail a physical copy of the completed form to The Entrust Group at 555 12th Street, Suite 900, Oakland, CA, 94607.
You may be asked to upload supporting documents if you are completing an in-kind distribution or if you’re completing the paper form.
Cash Distributions vs In-Kind Distributions
Taking a distribution with cash or publicly traded stocks and bonds is simple. These assets are fairly liquid, and you can easily convert them into cash to facilitate the distribution process.
However, SDIRAs allow ownership of illiquid alternative assets like real estate or private equity. Taking a distribution from these investments might seem more challenging. After all, how do you withdraw 3% of an apartment building or a tiny slice of a private company's shares?
Fortunately, taking a distribution from an SDIRA is more manageable than it seems. You have two methods at your disposal: cash distributions and in-kind distributions.
A cash distribution is exactly what it sounds like — a distribution of dollars and cents from your SDIRA to you.
In order to make a cash distribution, you need enough undirected cash in your account to fulfill the distribution request. If you have insufficient undirected cash in your account to cover your RMD, you’ll either need to liquidate an asset or take an in-kind distribution, which we’ll get to shortly.
Once you make the cash distribution request, Entrust will cut a check, wire, or ACH the funds from your SDIRA directly to you. We will record this distribution on IRS Form 1099-R, and the IRS will verify the amount. If the distribution meets the IRS rules, then the funds will retain their tax-advantaged status.
In-kind distributions involve receiving assets or investments directly from your SDIRA instead of converting them into cash. This allows you to maintain ownership of specific investments and offers the potential for continued investment growth.
For instance, let’s say your SDIRA’s only asset is a rental property. Last year, you submitted a Fair Market Value (FMV) of the property at $500,000. Now, it’s time to take an RMD. Due to your account value and age, you must distribute at least $25,000 from your traditional SDIRA. However, you don’t have the requisite cash in your account for your RMD.
To fulfill your RMD, your SDIRA distributes 5% of the ownership of the home to you personally. With real estate, this requires that you draft a new deed of the property designating the change of ownership. Keep in mind, this may be a time-consuming process. Make sure to allow enough time to complete the distribution and avoid late penalties.
Now, your SDIRA owns 95% of the home, and you own the other 5%. It’s that simple.
Note: As long as your SDIRA owns any portion of the asset, the asset is still under the prohibited transaction and disqualified person rule.
For example, if your SDIRA only owns 1% of the home and you own the other 99%, you still may not live in the home or rent it out to any disqualified persons. Otherwise, you risk disqualifying the tax-advantaged status of all assets held in the SDIRA.
Should I take a cash distribution or in-kind distribution?
This answer depends on your specific assets and financial goals. That said, here are some considerations to help you make an informed decision.
Liquidity: If you require immediate access to funds or need cash for specific purposes, a cash distribution might be suitable.
Potential for Growth: If you believe the distributed asset still has significant potential for growth or value appreciation, receiving the distribution in-kind may lead to a greater return.
Simplicity: If you have enough undirected cash in your account, taking a cash distribution is usually simpler. If you don’t have the requisite cash ready to be distributed, then you will have to take an in-kind distribution.
Ultimately, the decision between a cash distribution and an in-kind distribution depends on your individual circumstances, investment goals, liquidity needs, and tax considerations. Evaluate these factors carefully and consider seeking professional advice to make the choice that aligns best with your financial objectives.
Frequently Asked Questions on SDIRA Distributions
How do I calculate my RMD?
To calculate your RMD, use the RMD calculator from the SEC’s Office of Investor Education and Accuracy.
Simply plug in your age and the FMV of all tax-deferred retirement accounts (like a traditional IRA or 401(k)) at the end of the previous year.
Is there any way to reduce my RMD?
If you're at least 70½ years old, you can use your existing IRA distribution as a donation through a qualified charitable distribution (QCD), reducing your RMD. QCDs count towards required minimum distributions (RMDs) for those aged 73 or older.
To make a QCD, direct a portion of your RMD to a qualifying nonprofit. Qualified charities must be 501(c)(3) organizations eligible for tax deductions. Private foundations and donor-advised funds do not qualify, though recent legislation does allow gifts to charitable remainder trusts and charitable gift annuities.
Once you’ve made the QCD, contact your SDIRA provider so we can report it on IRS Form 1099-R. That way, the IRS can understand why you distributed an amount lower than your originally stated RMD.
When can I take an IRA distribution without penalty?
With a traditional IRA, you can start taking penalty-free, qualified distributions at age 59½. Remember, you will pay income taxes based on the distribution at your current tax rate.
To take a qualified distribution from a Roth IRA, you must be 59½ and have held the account for at least five years. However, there are some exceptions for early withdrawals from a Roth IRA. For example, you’re able to withdraw up to $10,000 for a first-time home purchase or certain qualified education expenses.
If you’d like a comprehensive list of all distribution exceptions, explore them on our traditional IRA Distributions page.
Does a distribution from my IRA affect my Social Security payment?
The Social Security Administration does not consider pension payments, annuities, interest, or dividends generated from your investments as earnings. Therefore, an IRA distribution will not reduce your Social Security retirement benefits.
Handle Distributions with Confidence at Entrust
Understanding SDIRA distributions is essential for effective retirement planning and maximizing the benefits of your self-directed account.
By familiarizing yourself with the rules and regulations, planning strategically, and seeking guidance from trusted advisors, you can navigate this stage of your retirement journey with confidence.
If you have a question about your unique situation, consult with a trusted tax or financial advisor.
Want to learn more about IRA rules? Download our SDIRA Rules Guide to learn more about the essential rules you need to follow to keep your account in good standing.
If you’re interested in even more in-depth information, browse our online course catalog. You can enroll in comprehensive lessons like Beneficiary Distribution Options and IRA Distribution Taxation taught by our experienced instructor, John Paul Ruiz QKA CISP.