No matter how far or close you are to retirement, you probably understand the importance of saving for the future.
Something we don’t talk about as much is withdrawing your money when you reach retirement age.
You may already be aware that you must wait until a certain age (59.5) before withdrawing funds from retirement accounts penalty-free.
However, there are penalties if you do not withdraw enough money after age of 72.
What Is a Mandatory Minimum Distribution?
Upon reaching 72 years old, you must withdraw money from your retirement account annually as required minimum distributions (RMDs).
You receive the cash, and Uncle Sam is taxed on the withdrawal.
During your working years, your retirement plans are tax-free, but the government does not want to lose its cut indefinitely.
That is why, except for Roth IRAs, most retirement accounts have required minimum distributions.
If you have one of the following retirement savings accounts, you must begin taking RMDs at the age of 72, according to the Internal Revenue Service:
- Traditional Individual Retirement Accounts
- SEPP IRAs
- Simplified IRAs
- Traditional 401(k) and 403(b) retirement plans
- Plans under 457(b)
- Profit-sharing schemes
- Other deferred compensation plans
Your 72nd birthday must have been reached by April 1 of the following year for you to begin taking RMDs.
If you don’t withdraw the money, you’ll owe a lot of money: Failure to take a distribution or withdraw enough can result in a 50% tax on the amount not taken.
IRS life expectancy tables determine how much you must withdraw from your account each year.
Must-Know Facts About Required Minimum Distributions
Minimum distributions are not inherently bad. Most of us want — or, honestly, require — to use the retirement funds we’ve been saving for years.
You may even consider yourself fortunate. Many work their entire lives and still run out of retirement funds before age of 72. Unfortunately, there is no way to avoid taxes once RMDs begin.
Here are eight important facts about RMDs that will help you prioritize how much you save now and how much you withdraw later.
Except for one, all retirement accounts require RMDs.
RMDs are required for all retirement accounts, whether individual or employer sponsored. Even Roth 401(k) and Roth 403(b) plans are subject to minimum distribution requirements once you reach the age of 72.
Roth IRAs are the one exception.
RMDs are not required for Roth IRAs while the account holder is alive. As a result, these retirement accounts are an excellent tool for young investors because the money can grow tax-free for the rest of your life.
You may be able to postpone your required minimum distribution.
It is possible to defer taking RMDs on an account in which you actively contribute to a 401(k) or 403(b) plan when employed by an employer who offers such a plan. You can postpone RMDs on that account until April 1 following your retirement.
However, this “still working” exception only applies to a current employer’s retirement plan and does not apply to IRAs or tax-deferred plans from previous employers.
That is a good reason to roll over any 401(k)s from previous employers into your current 401(k) before age of 72.
Deferring your required minimum distribution depends on whether your employer allows it.
Every year, the amount of your RMD will change.
The RMD amount you must withdraw is determined by the amount in your account and your life expectancy. You can use an online calculator to get a precise estimate of your withdrawal amount.
Because these variables change each year, so does the amount of your RMD.
Distribution needs typically follow a bell curve, increasing in the first half of retirement and decreasing in the second.
Excess withdrawals cannot be applied to next year’s distribution. Overdrawing your RMD is never a problem.
Different RMD rules may apply to different accounts.
If you have multiple retirement accounts, each will have its own set of RMD rules, so you must calculate them separately.
For example, you can combine multiple traditional IRA accounts (including SEP IRAs and Simple IRAs) and take a single RMD.
Plan types with defined contributions, such as 401(k)s, are not subject to this rule.
RMDs must be calculated separately for each 401(k) account if you have more than one. Remember, when you leave a job, you should transfer your 401(k) to your current employer’s or a traditional IRA.
Some RMDs can be avoided with rollovers.
If you have a Roth 401(k) or Roth 403(b), you can roll it over to a Roth IRA tax-free and avoid paying RMDs for the rest of your life.
Also, traditional IRAs can be converted to Roth IRAs. It protects money you want to keep investing in the market, which is beneficial if your retirement savings are limited.
It is important to note that converting a traditional IRA to a Roth will result in income tax liability. Suppose you have a significant amount of money in a traditional account or are currently in a high tax bracket. In that case, you should consult a financial advisor before converting to a Roth IRA.
It is critical to understand when to take your RMDs.
It is critical to understand your required minimum distribution deadlines. Otherwise, you will be fined.
Here are the two RMD deadlines to be aware of:
You must take your first RMD one year after turning 72.
Following that, you typically have until December 31 of the current year to take the RMD for that year.
If you decide to postpone your first RMD until April, be cautious. You’ll still have to take another distribution in December and taking two large withdrawals in the same year may push you into a higher tax bracket — and thus increase your tax bill.
There are penalties for failing to comply.
If you fail to comply with RMD rules, you will be charged income tax plus a penalty equal to 50% of your unwithdrawn distribution.
If the correct required minimum distribution is $4,000 and you only withdraw $2,000, you’ll owe a $1,000 tax penalty — half of $2,000.
If you made an honest mistake and did not withdraw enough money from your qualified plan, you can file Form 5329 – Additional Taxes on Qualified Plans with your tax return.
If you act quickly and notify the IRS, the IRS is known to waive penalties for incorrect RMDs.
You should also notify your retirement plan administrator of your intention to take RMDs. Some plan administrators, such as Vanguard, even provide a free service that calculates your RMDs automatically and transfers the money to a specified account at a specified time.
Some people are exempt from RMDs because they require the funds sooner.
Remember to take penalty-free withdrawals from a retirement account as early as age 59.5.
(Most) RMDs are subject to taxation.
Withdrawals from tax-sheltered retirement accounts are taxed at your regular income tax rate. Determine your tax bracket to determine how much money you’ll owe in taxes.
Your required minimum distribution is also included in your annual taxable income.
You may not be able to pay Medicare and Social Security taxes if you have a large nest egg because RMDs may send you into a higher tax bracket.
Roth account withdrawals are tax-free because the money in these accounts has already been taxed, and Roth withdrawals also do not count toward your taxable income.
Know Where to Go for RMD Assistance
Unless you enjoy math and numbers, calculating your RMD can be difficult.
And, as previously stated, mistakes can be costly.
Using an RMD calculator is wise so you don’t withdraw too much or too little from your accounts.
Do you need assistance reporting an RMD on your tax return? Consult with a tax professional. This is wise, especially if you must pay federal and state taxes.
You can also consult a certified financial planner about spending or investing your withdrawals.
IRS Publication 590-B is the best source of information on RMDs. It includes step-by-step instructions, worksheets, and distribution period tables based on life expectancy.