Required Minimum Distributions – Here’s How They Work
Posted in: Retirement Planning
Published: January 31, 2020
You’ve been putting money away in your IRA for much of your life. And through some mixture of discipline, good fortune and wits you find that you don’t have to use your IRA savings the moment they become available to you at age 59½. Good for you.
Now, upon reaching age 72, (previously age 70 ½ prior to the passing of the SECURE Act in December 2019) you must completely change your mindset because the U.S. Government requires you to start withdrawing money at that point. It’s called Required Minimum Distributions (RMDs).
At first, it may feel like a tax on getting old, but it’s not. RMDs are just another component to be considered as you plan for the decumulation phase, as opposed to the accumulation phase of finances. Let’s walk through the what, why, when, and how much of Required Minimum Distributions.
What are Required Minimum Distributions?
The IRS requires that you start taking withdrawals from your qualified retirement accounts (Traditional IRA accounts, 401(k)s, 457 plans and other tax-deferred retirement savings plans like a TSP, 403(b), TSA, SEP, or SIMPLE) once you reach age 72. (Note – If you began RMDs in the year 2019, even though you may not yet be age 72, you must continue to take them – you can’t pause and resume at 72. The age 72 age applies to those who reach age 70 ½ in the year 2020 or later.)
RMDs are not required for Roth IRAs, but Roth 401(k)s are subject to RMDs. To avoid the RMD on a Roth 401(k) upon retirement you can rollover that portion to a Roth IRA.
Also, if you inherit a Roth IRA, you will have to take RMDs from the inherited account. The IRS won’t let you leave it there and grow it tax-free for generation after generation. With the passing of the SECURE ACT, the account must be fully liquidated 10 years after the year of inheritance in order to avoid penalties.
When do I have to start making RMDs?
You must take your first RMD the year you reach age 72, but the IRS gives you until April 1 of the year following the calendar year in which you attain age 72 to withdraw that first required distribution.
Each year after that, your distribution must be taken by December 31st. If you miss the December 31 deadline, you can be forced to pay a whopping 50 percent tax penalty on the amounts not withdrawn in time.
You don’t have to wait until the end of the year – you can take the withdrawal any time during the calendar year, and you can set it up as monthly, quarterly, or annual distributions. You can also have taxes withheld directly from the distributions.
It’s usually most tax-efficient to take your first RMD in the year you reach 72, and not wait until April 1 of the year after you reach 72; if you wait, you’ll have to take two distributions in that second year, and that will likely make your taxable income quite a bit higher that year. You can calculate the taxes doing it either way and then take the option that will result in the least total taxes over those two years. With the hundreds of retirees we have worked with, we have seen very few cases where it made sense to delay the first RMD.
How much do I have to take out of my tax-deferred accounts?
The amount of your required distribution is determined by a formula that uses your prior year’s December 31 account balance, and a divisor, which is based on your age. Your age, for these purposes, is your age at your birthday in the year of your distribution. So if you are taking a distribution in 2020, use the age that you become on your birthday that occurs in 2020.
The IRS lists the divisor in a series of published tables. The right table to use depends on your situation. Most people will use the worksheet called Table III (Uniform Lifetime). If you have a spouse younger than you by ten years or more, and they are the sole beneficiary of your IRA, then you use a worksheet called Table II to determine how much to take out.
Here’s an example. Rick is retired and turned 72 in July 2020. His combined IRA and 401(k) balance on December 31, 2019, was $850,000. For Rick, the divisor, or “distribution period,” which is based on life expectancy, is 25.6. Rick takes the year-end balance of $850,000 and divides it by 25.6 to calculate how much he has to take out. This means Rick will have to withdraw $33,203.13 and pay taxes on that amount. The distribution period decreases every subsequent year because his life expectancy decreases. When Rick is 88 years old, for example, he will divide his retirement account balance by 12.7 to determine how much to withdraw (7.9 percent).
Can I rollover my RMD to a Roth?
You cannot roll an RMD to a Roth account or convert an RMD to a Roth. You can, however, take an “in-kind” RMD distribution. To do an in-kind distribution instead of distributing cash from the IRA, you transfer shares of an investment from the IRA to a non-IRA brokerage account.
For example, if you were required to take $13,000 out, you could transfer out 650 shares of a mutual fund that traded at $20 or more per share. You now have no trading costs and the funds remain invested. At the end of the year, your IRA custodian will send you a 1099R which reports the amount of the taxable distribution. You’ll still pay tax on the amount distributed, but the shares remain invested.
If you don’t need the cash, and you want to be charitable, then direct your RMD to a charity by using a Qualified Charitable Distribution (QCD). The amount of your RMD that is a QCD is not included in your adjusted gross income (AGI) on your tax return. Lowering your AGI can help reduce taxes in many ways.
What if I’m still working?
An exception is made for RMDs on your 401(k) if you are still working. If you are working after age 72 and you are not a 5% or more owner of the business, then you can delay distributions from your 401(k) at the company you work at until April 1 of the year after you retire. (If you have other IRA accounts the RMDs are still required on those.)
In hindsight, was putting pre-tax contributions into retirement accounts smart?
In most cases, it was a good deal for you to defer the taxes all these years.
The idea is that a lower tax rate applies in retirement because typically your total income in retirement is less than when you were working.
However, if you were a good saver and have a lot of money in retirement accounts, you may be surprised to find that because of all the extra taxable income from your required distributions, a pretty high tax rate applies after you are over age 72.
With the new Secure Act rules, we have two extra years to do planning. From the ages of 55 to 72 there are usually significant tax planning opportunities.
With planning, we help upcoming retirees take advantage of any legal ways to lower their tax bill in retirement. Smart planning that includes looking at all the required distribution rules can help you find ways to lower the tax liability during your retirement years.