Saving money in an IRA or 401(k) is one of the best ways to prepare financially for retirement.
These investing accounts offer tax benefits, including deferral of taxes on funds contributed to traditional IRAs and 401(k)s.
But there’s a provision in IRAs and 401(k)s that can trip up unsuspecting retirees. Known as required minimum distributions (or RMDs), this provision requires retirees to start withdrawing money and paying taxes on withdrawals when they reach a certain age.
What is a Required Minimum Distribution (RMD)?
The RMD rule is fairly simple. When you reach age 72 — or age 70½ if this was before January 1, 2020 — you have to start withdrawing a minimum amount of money from your traditional IRA or 401(k) each year.
The required amount is based on your account balance at the end of the previous year. This amount is divided by the applicable distribution period or an age-based life expectancy factor to arrive at your RMD.
Consult IRS Publication 590-B (Appendix B) for life expectancy tables that can be used to determine this amount. New life expectancy tables were updated in 2022. This was the first update since 2002. These changes went into effect on January 1, 2022.
Following are some of the most common questions many people have about required minimum distributions.
When Do RMDs Start?
You have until April 1 of the year following the year you turn 72 (or 70½ if this is before January 1,2020) to withdraw your first RMD. For example, if you will turn 72 on October 1 of this year, you’ll need to take your first RMD on April 1, 2023. Each year thereafter, you must take your annual RMD no later than December 31.
What Percentage is the RMD?
The required withdrawal amount is a percentage of the account balance. This starts at about 3.5% at age 70½ and increases with age: The SECURE Act increased the RMD age to 72 from age 70 ½. This, paired with the new RMD life expectancy tables, will slightly decrease the amount required to be distributed, which will allow retirees to keep more funds in their retirement account to provide the possibility of living longer.
Are RMDs Taxed?
Just like all funds withdrawn from qualified retirement accounts, RMDs are considered taxable income. Therefore, taking RMDs will result in higher reported income on your tax return and, thus, higher income taxes during the year they are taken.
What Types of Retirement Plans Require Minimum Distributions?
RMDs are required for all employer sponsored retirement plans including 401(k), 403(b) and 457 plans. They are also required for traditional IRAs, SIMPLE IRAs, SEPs and SARSEPs. They are not required for Roth IRAs while the original account owner is still alive because taxes have already been paid on the funds in these accounts.
What If I Don’t Take RMDs?
The penalties for failing to comply with RMD provisions for IRAs and 401(k)s are steep. If you don’t take RMDs when you’re supposed to, you could be penalized 50 percent of the amount of the distribution that should have been taken.
What If I Inherit an IRA?
If you inherit a traditional IRA and the original owner had started taking RMDs at the time of death, you must continue to receive the distributions as previously calculated during the year of the original owner’s death. After this, the amount of your RMD will depend on your status as a beneficiary (e.g., a surviving spouse or minor child).
One rule change in 2022 for inherited IRAs is that the IRS included a transition rule for non-spouse beneficiaries who inherited an IRA prior to January 1, 2022 after RMDs have begun, and are using the Single Life Table. The transition rule has the life expectancies “reset” using the new tables.
This “reset” will look like this: The beneficiary will “go back” to the year after the owner’s death and find their single life expectancy as of their age in that year using the new table. Then, one year will be deducted from the new life expectancy for each year since the first distribution year to get the divisor for the relevant post-2021 year.
This can be complex as there are different rules for different years. Talk to your financial advisor and tax planning professional about your RMDs.
How to Calculate RMDs
To calculate the amount of your RMD, you will divide the account balance on the prior December 31 by your life expectancy factor. The IRS has published life expectancy tables you can use for this purpose, which can be found here.
There are three different life expectancy tables. Use the one that applies to your situation:
Joint and Last Survivor
Single Life Expectancy
2022 RMD Deadlines
If you will turn 72 years old at any time in 2022, you must take your first RMD by April 1, 2023. You will then have to take your RMD each year thereafter by December 31 of that year.
Note that you are responsible for calculating and taking your RMDs on time every year. The IRS will not make this calculation or distribute the funds for you.
The Penalty for Missing the RMD Deadline
If you don’t take your RMDs on schedule, or don’t withdraw the full amount of the RMD by the deadline, you could be taxed at the rate of 50 percent on the amount of the distribution that wasn’t taken. You should file IRS Form 5329 along with your federal income tax return to report this tax payment.
This penalty tax could be waived if you can demonstrate that missing the RMD deadline was due to a reasonable error and you’re taking reasonable steps to correct it. To request a waiver, file IRS Form 5329 along with a letter of explanation.
Strategies Around RMDs
Fortunately, there are some strategies that can help lessen the potential impact of RMDs on your retirement finances. Here are five ideas to consider:
1. Reinvest the money.
Depending on your financial situation in retirement, you might not actually need to withdraw money from your IRA or 401(k) when you turn 72 years old to meet your retirement living expenses. In this case, you could simply transfer the money into a taxable brokerage account and reinvest it there.
2. Make withdrawals from your retirement accounts strategically.
For example, if you have multiple IRAs, you can determine the total amount of RMDs that must be withdrawn from all of them and make distributions from each account in whatever amounts you like. But the rules are different if you have more than one 401(k). Here, you have to take the correct amount of RMDs from each account separately.
3. Be aware of RMD exceptions.
There’s at least one important RMD exception with 401(k)s. If you’re still employed after reaching age 72, you generally won’t have to make withdrawals from your current employer’s 401(k) if you participate in it. But if you have 401(k) accounts from former employers, you’ll have to take RMDs from them on schedule.
4. Make a Qualified Charitable Contribution (QCD).
This is an estate planning technique whereby you will donate IRA funds directly to a qualified charity. In doing so, no tax is due on the distribution. As a bonus, you may receive a tax deduction for the charitable contribution. Important:You must direct your IRA custodian to make the check payable to the charity and send the check directly to them without withholding any income tax.
5. Consider a Roth IRA conversion.
You do not have to take RMDs from Roth IRAs because these funds have already been taxed. Therefore, converting a traditional IRA to a Roth IRA eliminates the issue of RMDs altogether.
Keep in mind there are other tax consequences involved with Roth IRA conversions. The biggest is the fact that income taxes are due on the value of the IRA when the conversion is done. This can result in a large tax bill that’s due in full all at once.
Plan RMD Strategies Now
The time to plan RMD strategies is before, not after, you reach the age when distributions are required. So give some thought now to how you will manage RMDs when the time comes.
Still have questions about how to handle RMDs? Get in touch with Personal Capital’s financial advisors for personalized insights on your financial plan.