Beginning April 1 of the year after you turn age 72 (or 70½ if you reached that age prior to January 1, 2020), and every year thereafter, IRS rules say you must take required minimum distributions (RMDs) from all of your qualified accounts. These include your employer 401(k) and 403(b) accounts as well as any traditional IRAs. Failing to withdraw the proper RMDs will subject you to IRS fines and penalties of up to 50% of the amount you should have withdrawn.
Want to figure out how much to take and from which accounts to take it?
To determine your RMDs, you’ll need to reference the IRS Uniform Lifetime Table, which calculates an average life expectancy factor based on your current age:
Example: If you’re age 72 in 2021, your life expectancy factor is 25.6 years. Assuming you have a total of $500,000 in your IRAs, you would need to withdraw $19,531 ($500,000/25.6) to satisfy your RMD requirements for the year.
Keep in mind that since both your account balance and your life expectancy factor will change each year, your RMD amount will also change. There are three additional IRS rules you’ll need to take into consideration:
1. If you have multiple employer-sponsored 401(k) plan accounts, in most instances you’re required to calculate and withdraw separate RMDs from each account;
2. For all your traditional, rollover, SIMPLE and SEP IRAs, you can simply add up the individual RMD amounts and withdraw the total from whichever account(s) you prefer; and
3. You are not required to take distributions from an employer-sponsored retirement plan (even if you’re age 72 or older) as long as you’re still employed by the firm.
What happens if I forget or make a mistake?
Calculating annual RMDs can be complex. Deadlines can be confusing. And mistakes are often costly. That’s why it’s always a good idea to seek out your advisor’s assistance. Not only can they help you calculate your RMDs, but they can show you the most strategic way to take your distributions.
Example: Perhaps due to market gains, your overall asset allocation has shifted too heavily towards equities. If you have two IRAs—one holding mostly stocks and the other holding mostly fixed income—it may be more beneficial to sell stocks and take your RMDs from the first IRA to help rebalance your portfolio and reduce your overall investment risk.
The benefits of advance planning for RMDs can’t be overstated. If you are in your late 50s or 60s, now’s the time to begin planning how to minimize your taxes when you’re in your 70s. Not only can large RMDs push you into a higher tax bracket, they could also cause up to 85% of your annual Social Security benefit to be subject to federal income taxes.
In some cases, it might be advisable to take small, penalty-free annual distributions when you are in your 60s (before RMDs kick in). Or you may want to consider converting a portion of your traditional IRA into a Roth IRA each year. Although you would have to pay income taxes on any amount converted, it may be at a lower tax rate if you're already retired and haven’t yet started taking RMDs. Roth IRAs offer continued tax-deferred growth with no RMDs, and provide tax-free future withdrawals or a tax-free inheritance for your heirs if you never need the assets.
What if I don’t need the income from RMDs?
For the most part, RMDs are an inevitable payback to the IRS for the privilege of years of tax-deferred growth. But if you’re fortunate enough not to need the income, there are other ways to put those assets to work.
- If the rising cost of healthcare worries you, you could use annual RMDs to build an emergency fund to cover any unexpected future healthcare costs (or use them to pay the premiums on a long-term care insurance policy).
- If you’re looking to maximize the legacy you leave for your heirs, RMDs can fund the annual premiums on a life insurance policy held in an irrevocable life insurance trust (ILIT). The death benefit associated with the insurance policy can be quite large, and your beneficiaries won’t have to pay taxes on any of the insurance proceeds they receive.
- If making a charitable impact is important to you, the Tax Cuts and Jobs Act added incentives to allow for tax-free transfers of RMDs directly from your IRA to any 501(c)(3) registered charity.
Of course, pursuing either of the first two strategies will still necessitate paying taxes on your RMDs.
Your advisor can help you explore whether or not a particular strategy aligns with your overall financial plan. You may also want to think about consolidating your retirement accounts to make a complete and accurate view of your entire retirement picture easier.
By approaching your RMDs more thoughtfully, your retirement assets will be able to meet your needs today, as well as for years to come.