As you approach the age of 72, it’s time to start thinking about taking required minimum distributions (RMDs) from your retirement accounts such as 401(k)s, 403(b)s, and individual retirement accounts (IRAs). There are many rules and requirements surrounding these mandated withdrawals to be aware of—not to mention tax ramifications.
To avoid costly mistakes, such as withdrawing the wrong amount or forgetting to take a distribution altogether, it’s a good idea to make a long-term plan that maps out your retirement distribution schedule.
What is a required minimum distribution?
An RMD is a mandated annual withdrawal from a retirement account such as an IRA or 401(k). It’s the minimum amount you must withdraw after reaching a certain age in order to comply with federal tax laws.
“After you reach age 72, the IRS requires you to distribute some of your retirement savings each year from qualified retirement accounts like a 401(k), 403(b), and most IRAs,” says Sri Reddy, senior vice president of retirement solutions for Principal Financial Group. “However, there are certain exemptions that qualify for delay—if someone is still working at age 72, and they don’t own more than 5% of a business, they can wait to start RMD until April 1, following the year they retire.”
Roth IRAs, which are funded with after-tax money, represent yet another exception to distribution rules. There are no required minimum distributions with these accounts, meaning the money can be left in the IRA by the original owner for their entire lifetime if desired.
For other retirement savings accounts, the required minimum distributions must be taken during retirement, whether or not you need the money.
“Taking the RMD is a routine task for many retirees, but there are specific situations where more consideration should be given to your options,” says Melissa Shaw, wealth management advisor for TIAA.
Mistakes to avoid with required minimum distributions
1. Delaying your first RMD
Generally, you’re required to take RMDs by December 31 each year. However, for the first year after you turn 72 and are retired, you have until April 1 of the subsequent year to take your initial distribution.
But if you take advantage of that extended deadline, you will then have to take two distributions within a 12-month timeframe. This is because you’ll still need to take your next annual minimum distribution by December 31 of that year.
Taking two RMDs in one year can impact your annual income as the distributions are taxed as ordinary income. Too much income in one year from retirement accounts can potentially put you into a higher tax bracket.
2. Forgetting to take your RMD
Another common mistake is simply forgetting to take your RMD. The IRS assesses a 50% penalty on the RMD amount if you don’t take it by the annual deadline.
“This is a completely avoidable penalty,” says Shaw. “Most financial institutions give you options to set up automatic RMD withdrawals each year. These withdrawals can be set to monthly distributions if you need to replace your income, semi-annual distributions, quarterly distributions, or annual distributions. Automating your RMD withdrawals is a good way to ensure it will be taken care of, even if you forget about it.”
3. Mixing plan types to meet RMDs
For those who have multiple types of retirement accounts, it’s important to understand the rules regarding annual distributions for each individual account. Most importantly, you are not allowed to use withdrawals from different types of retirement accounts—such as an IRA and a 401(k)—to meet the annual RMD threshold for one of those accounts.
For instance, you cannot take withdrawals from both a traditional IRA and your 401(k) in order to simply meet the RMD requirements for your traditional IRA. On the other hand, if you have several retirement accounts of the same type—such as multiple traditional IRAs, you can use withdrawals across those accounts to meet your annual RMD for one.
“If someone has more than one traditional IRA account, they can take the total IRA RMD from one of the IRAs or from any combination of them,” explains Reddy.
There’s also a distinction to understand with regard to employment plans you hold with past employers you may have worked with over the course of your career. Here too, there are specific nuances that must be followed carefully.
“For those with an employer-sponsored retirement plan from a former employer, the RMD must be taken directly from that plan. If they have more than one former retirement plan, it’s required to take RMD from each plan separately, with no consolidation permitted,” adds Reddy.
4. Combining RMDs with your spouse
While there are a host of financial benefits to consider as part of a marriage, retirement accounts must be held individually. They are not joint assets. And that reality impacts how RMDs are handled. Often, couples assume they can take the entire annual required distribution out of one spouse’s account. But that is not the case.
“This will be viewed as a missed distribution for the non-withdrawing spouse, activating the 50% excise tax guideline on that distribution,” says Reddy. “As well, that larger distribution from the withdrawing spouse can have several tax implications, including the possibility of pushing [annual income] into a different income bracket.”
5. Withdrawing the wrong amount
Finally, it’s important to calculate your RMDs correctly. Withdrawing less than your RMD, for instance, may result in a tax penalty of up to 50% of the amount you were required to withdraw. There are RMD calculators available online that can help you sort through the complicated task of determining the correct withdrawal amount.
Most importantly, you must calculate your annual RMD using the account balance as of December 31 of the previous year. But that’s not the only consideration.
“RMDs are calculated by dividing the December 31 balance of each account by life expectancy, as estimated by IRS life expectancy tables,” explains Reddy. “As retirees get older and life expectancy decreases, RMD will increase. At age 90, for instance, the withdrawal amount is almost 10% of an account’s value.”
The IRS provides worksheets to help with these calculations. In addition, many financial institutions calculate RMD for plan participants. But, the account holder is still responsible for withdrawing the correct amount.
Making a long-term plan for required minimum distributions
One of the best ways to keep track of your RMDs and manage the tax bills associated with your withdrawals is to develop a long-term plan mapping out your distributions. This is particularly essential if you have multiple retirement accounts that you’ll be juggling.
Talking with a financial advisor can be helpful when developing this type of plan.
“When considering a long-term plan, it’s important to factor in basic needs, potential health care expenses, and the lifestyle you want to live in retirement,” says Reddy. “This will help you understand your drawdown plan when it comes time to take an RMD each and every year. These considerations should be thought through in the five or so years leading into your proposed retirement.”
The takeaway
Required minimum distributions can have a significant impact on your retirement income. If you miss withdrawal deadlines or withdraw the wrong amount, it may trigger costly consequences, including a tax penalty of 50% on your RMD and bump you into a higher tax bracket for the year. Understanding the rules and regulations surrounding how you meet annual RMDs from different types of retirement accounts is also critical.
Creating a long-term plan that maps out how your RMDs will be handled and when they will be taken can help you avoid expensive mistakes.
