It’s essential to save for retirement, and special retirement accounts give you tax breaks for setting money aside for your retirement nest egg. IRAs, 401(k)s, and other tax-favored accounts offer a combination of upfront and future tax benefits that can add up to thousands of extra dollars to go toward your retirement needs.
Lawmakers didn’t want people keeping money in retirement accounts forever, so they established rules for required minimum distributions, or RMDs for short, from your retirement savings. The rules for RMDs just changed, however, so you’ll need to familiarize yourself with two key new provisions in order to avoid the severe consequences if you don’t take proper withdrawals in retirement.
What is a required minimum distribution?
The tax laws force retirement savers to take required minimum distributions out of certain types of retirement accounts upon reaching set ages. Those with traditional IRAs, 401(k)s, or any of several other types of employer sponsored retirement plans usually must take RMDs once the provisions of the law kick in. The RMD rules also require withdrawals from certain inherited retirement accounts.
The calculated amount of the required minimum distribution must be taken in cash, and you’re generally required to complete the withdrawal by the end of the calendar year. A one-time extension applies that gives you until April 1 of the following year to make what for most people is their first RMD (more on that below), but after that, Dec. 31 becomes the deadline you’ll need to pay close attention to in order to comply with the requirements.
Why do I have to take an RMD?
Required minimum distributions put limits on the tax benefits you can get from retirement accounts. With a traditional IRA, 401(k), or similar account, you get an upfront tax deduction for the amount that you contribute toward retirement. You also get tax-deferred treatment of any income and gains that the assets in your retirement account generate. No tax is due until you start making withdrawals.
Without RMDs, people could potentially keep their retirement savings in these accounts throughout their lives and never pay taxes. The RMD rules change that by establishing time limits on how long savers can keep their retirement accounts untouched. That ensures that the IRS will eventually get its share in taxes — even if savers don’t actually need the withdrawals to cover their living expenses.
When do I have to start taking RMDs?
When you have to take RMDs depends on your particular situation. If you’re the original accountholder, then you’ll need to start taking withdrawals in the year in which you turn 72 years old. Those who’ve just turned 72 in a given year have until April 1 of the following year to start taking their required minimum distributions. After that one-time extension, withdrawals in subsequent years must be complete by the end of the calendar year.
This is the first major change to RMD rules, because the RMD age used to be 70 1/2 until the most recent tax law changes took effect in late 2019. That means that if you turned 70 1/2 in 2019, you’ll need to follow the old laws that require earlier RMDs.
Those who inherit IRAs (including Roth IRAs), 401(k)s, or other retirement accounts have to follow different rules. Spouses are allowed to roll over inherited retirement accounts into IRAs in their own names. However, others are limited to electing to take a one-time lump sum or to withdraw all money from the account within 10 years. These rules take effect immediately — not at age 72 — so those of any age must take distributions.
This 10-year provision is the second major new change to RMD rules and takes effect for those inheriting retirement accounts in 2020 or later. For those who inherited retirement accounts in 2019 or earlier, different rules apply, allowing heirs to take withdrawals that are stretched out over the course of their lifetime. This last option involved calculating required minimum distribution amounts for each year in order to ensure that you’re taking enough money out to satisfy the IRS.
How big does my required minimum distribution have to be?
The hardest part of complying with RMD rules is calculating the amount of your required minimum distribution. In general, the IRS wants to make sure you take out all of your retirement savings over the course of your lifetime. Accordingly, for most taxpayers, it refers to life expectancy tables to help taxpayers figure out what the size of each year’s required minimum distribution needs to be.
Once you have all the required information, the math involved in calculating the RMD is a simple three-step process.
- Add up the value of the retirement accounts that are subject to the RMD rules as of Dec. 31 of the previous year.
- Find the appropriate distribution factor by referring to the appropriate IRS life expectancy table that applies to your situation.
- Divide the total retirement account balance by the distribution factor. The result is how much you’ll need to withdraw for that given year.
Where things get complicated is in finding the distribution factor. That’s because there are multiple IRS tables that provide life expectancy estimates, and different tables apply to various situations.
For your own retirement account, the most commonly used distribution factor table is the one copied below:
Typical RMD table for retirement accountholders
|Age||Distribution Factor||Age||Distribution Factor||Age||Distribution Factor|
Data source: IRS.
What this tells you is that if you’re 72 years old, then according to the IRS life expectancy tables, you’re expected to live another 25.6 years. So if you turn 72 in 2020, then to determine this year’s RMD, you’d take your account balance as of Dec. 31, 2019. You’d then divide it by 25.6. The result would tell you how much you have to withdraw. The following year, you’d take your account balance as of Dec. 31, 2020, and then use the factor for 73 year olds, 24.7. Divide the balance by the factor and you’d have your RMD for 2021.
However, there are a couple of special cases. First, if you’re married and your spouse is more than 10 years younger than you are, then there’s a special table that has slightly different life expectancy calculations. Because the table has to include not only your age but also the age of your spouse, it’s far too long to duplicate here. However, you can find it by clicking the link for this IRS publication, and then searching for Table II, the joint life and last survivor expectancy table. Here too, you’ll continually refer to the table over the course of your lifetime in order to figure out the new factor each year.
Also, if you inherited a retirement account in 2019 or earlier, then a different set of tables applies. As mentioned above, those who inherit an IRA typically have to take RMDs regardless of their age, so the table covers anyone from newborns through centegenerians.
RMD table for beneficiaries of inherited retirement accounts
|Age||Distribution Factor||Age||Distribution Factor||Age||Distribution Factor||Age||Distribution Factor|
Data source: IRS.
The rules for distributions for those who inherit IRAs are also different from retirement accountholders themselves in that you only refer to this chart once. Thereafter, instead of using the new factor for your age the following year, you reduce the factor you used the previous year by 1. So for instance, if you inherited an IRA in 2019 when you were 48 years old, you’d use the 36.0 factor for the first year of required minimum distributions. However, the following year, rather than using the 35.1 factor for 49-year-old people, you’d take 36.0 and subtract 1, getting 35.0 as the number by which you’d divide your account balance.
Again, keep in mind that those who inherit IRAs and other retirement accounts in 2020 and later won’t get to use this table. Instead, they’ll typically have to withdraw all of the account assets within 10 years, with the only exception being for surviving spouses.
What happens if I don’t take my RMD?
Large penalties apply to those who don’t take RMDs. If you don’t take out the full amount of your RMD by the appropriate deadline, then the IRS penalty is half the amount that you should have taken out. Based on current tax rates, that penalty will be larger in every circumstance than the amount of tax you’d have to pay if you correctly withdrew the required amount.
To some, the 50% RMD penalty seems extreme, but it does communicate just how much the tax laws want to put a limit on the tax benefits of retirement accounts.
What tax consequences do RMDs have?
The reason why many retirees really don’t like to have to take required minimum distributions is that their tax consequences are the same for any other withdrawal from a retirement account. For a traditional IRA, 401(k), or other employer-sponsored retirement account, the amount that you’re forced to withdraw is included in your taxable income for the year. In some cases, the extra income is enough to push you into a higher tax bracket, and that can have ramifications for how much tax you pay on other sources of income. For example, Social Security benefits become taxable when your countable income exceeds certain thresholds, and traditional IRA and similar distributions count toward those limits.
For those who inherit IRAs, the tax consequences of RMDs depend on the type of IRA in question. Traditional IRA and similar retirement accounts are treated the same for heirs as for the original accountholders. Heirs taking RMDs from Roth IRAs aren’t taxed on the distributions, but they do lose the ability to generate more tax-free income in the future from the accounts.
Some RMD examples
To make this clearer, let’s take a couple of examples. In the first, say you’re single and turn 72 in January 2020. You had traditional IRAs worth $100,000 at the end of 2019. The appropriate factor for a 72-year-old is 25.6. So you’d divide $100,000 by 25.6, and you’d get $3,906. That’s the minimum amount you’d have to withdraw in order to meet the RMD rules.
Now say the following year, your account has gone up in value to $110,000. You’ll be 73 next year, so you’d look up the factor for 73-year-olds and divide $110,000 by 24.7. That gives you $4,453 as your 2021 RMD.
Now let’s change the example somewhat so that instead of being single, you’re married to a spouse who’s 59. Because your spouse is more than 10 years younger than you, you need to look at the special IRS table for your situation. The factor here is 27.7, so dividing $100,000 by 27.7, you’d get a slightly smaller RMD of $3,610. The following year, the factor for spouses who are 73 and 60 is 26.8, so $110,000 divided by 26.8 = $4,104 — again, slightly smaller than the single case.
Can I reinvest my RMD?
Many retirees have enough alternative sources of income that they don’t really need the money they’re forced to withdraw from their retirement accounts. For them, reinvesting would be an ideal option.
You’re not allowed to reinvest your RMD back into your IRA or 401(k), nor are you allowed to take an RMD from one account and roll the amount over into another tax-favored retirement account. However, there’s nothing stopping you from taking your RMD, depositing it in a taxable brokerage account, and buying exactly the same investments you held in your retirement account. You won’t get the favorable tax treatment that an IRA or 401(k) allows, but you will continue to earn dividends as well as reaping profit from capital gains if the stock price continues to go up.
Know the rules
Finally, note that while the RMD rules force you to take at least a certain amount out of your retirement accounts, there’s nothing stopping you from taking more than the calculated required minimum distribution. By the time RMDs kick in, accountholders are old enough to avoid early withdrawal penalties, and there aren’t any such penalties for those who inherit retirement accounts.
Required minimum distribution rules aren’t always popular, because no one likes to pay taxes when they don’t have to. However, taking RMDs is essential to keep from owing the big penalties for those who fail to follow the rules. If you know the RMD rules, then you can pick a retirement withdrawal strategy that lets you get the most from your retirement accounts as long as possible.
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