Personal Finance 301: Required Minimum Distributions

What are Required Minimum Distributions?
    •    After age 72, the federal government requires that you annually withdraw a limited sum—called a required minimum distribution or RMD—from tax-sheltered retirement accounts. 
    •   RMDs must be withdrawn from tax-advantaged retirement accounts such as 401(k)s, 403(b)s, 457 plans,  traditional IRAs and other IRA-based plans such as SEP IRAs and SIMPLE IRAs. Roth IRAs are not subject to RMDs.
    •   If you fail to take RMDs, you will owe a stiff penalty equal to 50% of what you were required to withdraw.

Workers can sock away money for decades in tax-friendly retirement accounts, such as 401(k)s  and similar plans. They get a tax break upfront on their contributions and then can watch their investments grow tax-sheltered over time. 

But Uncle Sam wants to eventually collect his due. So, after savers reach the age of 72, they must start taking minimum distributions each year from these retirement accounts. (You can always take out more, of course). These withdrawals will be taxed at ordinary income tax rates. 

For retirees who have been tapping their accounts for living expenses throughout their sixties, RMDs may not be a big deal. But for those who don’t need the money just yet—or who have built up sizable tax-sheltered nest egg—RMDs can trigger a large tax bill and can even bump them into a higher tax bracket.

Some relief may be on the way. Given that people are living longer, the IRS recently proposed to update the way RMDs are calculated to reduce the amount older savers must withdraw. And pending legislation would raise the age limit when people must start RMDs. But even if these changes don’t come about immediately, retirees still have ways now to lower RMDs and their tax bills. 

What is the Deadline for RMDs?  
Annual RMDs must be taken by December 31. But if you’re making your first RMD, the IRS offers a little leniency. Your initial RMD must be made by April 1 of the year following the year that you turned 72. 

For example:
    •   If you turned 72 in 2020, the deadline for your first RMD would be April 1, 2021. 
    •    If you turned 70 in October 2020, you won’t turn 72 until 2022, so your deadline would be April 1, 2022.

Be aware, if you delay your first RMD until April, you will have to take your second RMD that same year by December 31. That not only can lead to a bigger tax bill, but the two withdrawals in the same year could push you into an even higher tax bracket. This is why many retirees take their first RMD by December 31 of the year they turn 72, rather than delaying until the April deadline.

How RMDs Are Calculated
The amount of your annual RMD will depend on your age, retirement account balance and your distribution period—a number published by the IRS. (This number is sometimes called your life expectancy factor).

To figure your RMD for the year, start by looking up your distribution period. Most retirement account owners will find this number listed next to their age on the Uniform Lifetime table (Table III) in IRS Publication 590-B. For example, the distribution period is 26.5 for a 71-year-old and 17.9 for an 81-year-old. If your spouse is more than 10 years younger than you and is your only beneficiary, you will use the Joint Life and Last Survivor Expectancy table (Table II).   

Next, divide your retirement account balance as of December 31 of the previous year by the distribution period to calculate your RMD. (If you’re taking an RMD for 2020, you’ll use your balance as of Dec. 31, 2019). For example, say, you’re 72 in 2020 and your IRA balance at the end of 2019 was $500,000. Your 2020 RMD will be about $18,868.

If you have more than one IRA, calculate the RMD for each and add it up. You can then take the total sum from one or more of the IRAs. 

The rules differ if you own multiple 401(k)s. Again, you calculate the RMD for each account, but you must withdraw the money separately from each 401(k). 

There are a few other exceptions to RMDs: 
    •    If you’re still working after age 72, you won’t have to take RMDs from your current employer’s 401(k) until you retire—unless you own 5% or more of the company. You’ll still have to take distributions from other 401(k)s you own.
    •    Roth IRAs are not subject to RMDs because contributions have already been taxed.
    •    And though retired Roth 401(k) owners must take RMDs from their account, the withdrawals won’t be taxed.

What If I Miss My RMD?
Failing to take a required distribution or not taking out the full amount can lead to a harsh penalty—50% of the RMD shortfall. 

You may be able to avoid this penalty by taking steps to correct the error as soon as it’s discovered. First, immediately withdraw the amount you should have taken out. Next, file a Form 5329 with the IRS. On lines 52 and 53, you’ll report how much you were supposed to withdraw and how much you actually did. On the dotted line next to line 54, write “RC”—which means reasonable cause—and the amount of the penalty you want waived. 

Also attach a brief statement explaining why you qualify for relief. Then, wait to hear back from the IRS. The agency can be forgiving, especially if this was your first RMD. 

You may be able to avoid RMD mistakes in the future by having your investment firm calculate the RMD each year and deposit the money in a bank or non-retirement account for you on a monthly or quarterly basis.

How to Reduce RMDs
So many older workers today have the bulk of their nest eggs parked in 401(k)s and other tax-deferred accounts that they have been referred to as the “RMD generation.” But older savers can make some moves to reduce their tax-deferred holdings and lower future RMDs.  

If you’re in your 60s, for example, you can withdraw money from tax-deferred accounts early in retirement when you might be in a lower tax bracket. You can use the money to help pay living expenses—perhaps allowing you to delay claiming Social Security and build up a bigger benefit. Or, if you have expenses covered, you can gradually convert some of the tax-deferred money to a Roth IRA. Once in the Roth, you won’t have to pay taxes on future withdrawals. 

Just make sure with either of these strategies that you don’t drain so much out of your tax-deferred account that you wind up in a higher tax bracket.
Also, those who have reached RMD age still have time to lower the tax impact of these distributions. If you are 70½ or older, you can directly transfer up to $100,000 a year tax-free from a traditional IRA to one or more charities. This qualified charitable distribution (QCD) will count toward your RMD without being added to your adjusted gross income. 

Before making any tax moves, it’s always a good idea to review them first with an accountant or financial advisor.